• AAII Model Portfolios
  • Shadow Stock Portfolio Performance Reflects Market’s Volatility

    by James B. Cloonan

    Shadow Stock Portfolio Performance Reflects Market’s Volatility Splash image

    The Model Shadow Stock Portfolio retreated during the four-month pullback in the stock market.

    The portfolio is now up just 1.7% year-to-date (August 31, 2010), but that is somewhat better than the S&P 500 which, as measured by the Vanguard 500 Index fund, is down 4.7% for the same period. As I write this, a September rally seems to be underway, but there has been so much fluctuation during 2010 that it may not last until you read this. Complete performance data can be viewed in Figure 1 and Table 2.

    The current holdings are shown in Table 1. As shown in Figure 2, the number of stocks passing the initial screen increased to 21. Many of those were already in the portfolio and, as usual, the final decision on a new purchase was based on liquidity and price-to-book ratios.

    Setting a Liquidity Level

    Those of you who use AAII’s Stock Investor Pro database and stock research program and run the included screen for the Shadow Stock Portfolio will always find more stocks passing than the number in my initial

    screen. That is because the screen included in SI Pro does not screen for liquidity. The required liquidity is a function of an individual’s portfolio. Because I am sharing my selections with a large number of individual

    investors, I require a larger daily trading volume than a single investor might require.

    Individuals must set the required volume to provide liquidity for their specific needs. For example, an investor with 20 stocks in a $50,000 portfolio could buy a stock with very low turnover in an individual holding. We have suggested requiring daily volume four times the amount of the holding. The investor mentioned above would

    only need average daily volume of $10,000 (4 × $2,500).

    Removing a Sell Rule

    After reviewing the history of the portfolio, we have decided to eliminate the portfolio’s “two-year rule,” which requires a stock to be sold after two years if it does not currently qualify as a buy and if there is another qualified buy to replace it. Stocks eliminated on this basis have performed just as well in subsequent periods

    as the general portfolio. Since turnover is the mortal enemy of small-cap portfolios, we chose to eliminatewhat appears to be unnecessary turnover.

    Portfolio Changes

    We sold one stock, MedCath Corp. (MDTH), for violating probation. This is the stock that slipped by being sold six months ago because of confusing earnings reports.

    We purchased one stock, Rex American Resources Corp (REX). A summary of the transactions can be seen in Table 3.

    Company (Ticker)
    52-Week Market
    ($ Mil)
    AeroCentury Corp. (ACY) 13.10 25.00 12.40 20.2 3.8 0.47 0.0 qualified as of 8/31/2010
    Alamo Group, Inc. (ALG) 19.50 27.05 13.04 230.2 10.3 0.99 1.2  
    Books-A-Million (BAMM) 5.41 13.72 5.27 85.1 6.0 0.75 3.7 qualified as of 8/31/2010
    Capital Senior Living Corp. (CSU) 4.96 6.49 4.21 134.3 35.4 0.82 0.0  
    CONN’S, Inc. (CONN) 4.36 12.99 4.30 97.9 nmf 0.28 0.0 earnings probation (2010q2)
    CSS Industries (CSS) 15.44 21.93 14.87 149.7 nmf 0.66 3.9 earnings probation (2010q2)
    Ennis, Inc. (EBF) 15.39 19.35 13.33 398.6 9.6 1.23 4.0  
    Flexsteel Industries (FLXS) 14.15 16.50 7.67 94.0 8.8 0.80 1.4  
    Hastings Entertainment (HAST) 7.39 9.38 3.60 66.1 11.0 0.64 0.0  
    Jackson Hewitt Tax Service (JTX) 0.78 5.91 0.75 22.4 nmf nmf 0.0 earnings probation (2010q3)
    Lithia Motors, Inc. (LAD) 7.64 16.49 5.18 199.6 44.9 0.65 2.6  
    Marlin Business Servs (MRLN) 9.75 13.60 6.56 125.5 33.6 0.82 0.0  
    Mitcham Industries, Inc. (MIND) 6.50 8.43 5.01 63.9 21.7 0.71 0.0 qualified as of 8/31/2010
    OYO Geospace Corp. (OYOG) 49.25 55.95 19.05 297.2 43.2 2.31 0.0 approaching value limit
    Paragon Shipping Inc. (PRGN) 3.64 5.49 3.40 186.5 2.8 0.39 5.5  
    PC Connection, Inc. (PCCC) 6.52 7.95 5.10 176.6 12.3 0.73 0.0 qualified as of 8/31/2010
    PC Mall, Inc. (MALL) 4.20 8.08 3.20 51.3 17.5 0.52 0.0 qualified as of 8/31/2010
    RCM Technologies, Inc. (RCMT) 4.97 5.29 1.98 64.6 12.4 0.97 0.0  
    Rex American Resources (REX)* 13.06 19.30 9.75 128.7 13.1 0.51 0.0 qualified as of 8/31/2010
    Saga Communications (SGA) 17.50 29.00 10.16 74.5 35.0 1.04 0.0  
    Shoe Carnival, Inc. (SCVL) 16.53 29.26 14.07 217.8 9.0 0.88 0.0  
    Standard Motor Products (SMP) 8.60 15.71 7.00 196.1 17.9 0.96 2.3  
    Standex Int’l Corp. (SXI) 23.53 30.93 16.56 293.5 10.7 1.51 0.9  
    SureWest Communica’ns (SURW) 6.18 13.32 5.90 86.3 nmf 0.32 0.0 earnings probation (2010q2)
    Twin Disc, Inc. (TWIN) 11.87 15.23 8.77 132.9 237.4 1.48 2.4  
    Willis Lease Finance (WLFC) 9.95 17.61 8.12 93.2 7.5 0.46 0.0 qualified as of 8/31/2010

    Explanation of Notes

    Approaching Size Limit: Stocks are sold if their market capitalization goes above three times the initial maximum criterion. The current market capitalization maximum for initial screening is $200 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $500 million.

    Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above three times the initial criterion. The current initial price-to-book ceiling is 0.80. Stocks are marked “approaching value limit” if their current price-to-book-value ratio exceeds 2½ times the initial criterion, or 2.00.

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    Earnings Probation: If last 12 months’ earnings from continuing operations are negative, the stock is put on probation; if a subsequent quarter has negative earnings prior to 12-month earnings becoming positive, the stock is sold. The date within the parentheses lists the fiscal quarter during which the company first reported negative trailing 12-month earnings.

    Qualified as of: Stock still qualified as a buy when the screen was run with current data. Stocks that don’t currently qualify as a buy are held until they meet one of the sell rules.

    See the Shadow Stock Portfolio area of AAII.com for more information.

    Purchase and Sales Rules

    Stock purchases must meet these criteria:

    • No bulletin board or pink sheet stocks will be purchased.
    • Price-to-book-value ratio must be less than 0.80. (Figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $17 million and $200 million. (Figure will change gradually with changes in overall market values.)
    • The firm’s last quarter and last 12 months’ earnings from continuing operations must be positive.
    • No financial stocks or limited partnerships will be purchased.
    • No stocks on foreign exchanges or ADRs will be purchased because of different accounting and/or withholding tax on dividends.
    • The share price must be greater than $4.
    • In order to reduce trading by avoiding stocks that are forever marginal, any stock that was sold within two years will not be rebought.
    • Note second item under Stock Order Guidance concerning spreads when buying shares.
    • Price-to-sales ratio must be less than 1.2. (Figure may change gradually with changes in overall market values.)
    • Stocks are sold if any of the following occur:
    • If last 12 months’ earnings from continuing operations are negative, the stock is put on probation; if a subsequent quarter has negative earnings prior to 12-month earnings from continuing operations becoming positive, the stock is sold.
    • The stock’s price-to-book-value ratio goes above three times the initial criterion.
    • Market capitalization goes above three times the initial maximum criterion.

    Stock Order Guidance

    • These rules are for general guidance. Your own experience, market conditions and the size of the position will impact your own decisions. The results in the model portfolio were obtained while sometimes paying more.
    • Market orders are not used. Instead, if the quoted bid-ask spread is less than 2% (ask price minus bid price, divided by ask price), place a limit order at the ask price for a buy and at the bid price for a sell. If the bid-ask spread is more than 2%, try to place a limit order between the bid and ask prices to keep transaction costs low. If necessary, build a position gradually. With low commissions, it is often better to place partial orders than to try to establish a large position all at once. Be patient.
    • Be careful if the average daily number of shares traded is not four times the amount needed for your position. It may be too difficult to get in and out of the position, but you may be able to grow the position gradually and sell gradually.
    • For NASDAQ stocks, it appears to be better to use day orders. If the order is not filled, it is placed again with a slight adjustment. For NYSE and Amex stocks, good-till-canceled (GTC) orders are used to keep a place in line in the specialists’ books. If the market isn’t close to the desired price, the price is adjusted in a few days with a new GTC order.
    • If price changes cause a stock to become ineligible (due to changes in price-to-book-value ratio or market capitalization) when only part of the order has been filled, stocks already purchased are kept but the balance of the order is canceled.

    Management Rules

    • Equal dollar amounts are invested in each stock initially.
    • Decisions are made only at the end of each quarter. In order to react to the majority of earnings reports as soon as possible, quarterly reviews are made in February, May, August, and November.
    • Best judgment is used for tenders or mergers, but all criteria must be obeyed.
    • At the end of a quarter, if receipts from stocks sold exceed requirements for new purchases, the excess receipts—up to 5% of the portfolio’s value—are kept in cash until the next quarter. If the excess receipts are greater than 5% of the total portfolio value, the amount above 5% is distributed to smaller holdings that still qualify as buys. Efficient quantities are purchased: If over 10% of the portfolio is in cash, the price-to-book-value ratio can be moved up, but never over 0.90.
    • At the end of a quarter, if receipts from stock sales are insufficient to buy all newly qualifying stocks, purchases are made in order of lowest bid/ask spreads.
    • Note that if you are managing your own portfolio, it should consist of at least 10 stocks. If you are developing the portfolio gradually, you can do it stock by stock, but don’t put more than 10% of your funds in each additional stock. More than 20 stocks is not needed until the portfolio exceeds $1 million.


    Volatility remains high. There seems to be a little too much bearishness, which should lead to some market

    strength in the near term. But any such strength might not last. As I mentioned early in the year, this should

    be an average year based on election-cycle history. The average of year two in the cycle over the last 75 years has been 11.5%. It might well turn out to be an average year in rate of return, but it certainly has not been average in volatility.

    The year and the mid-term elections will be over before my next column on the Model Shadow Stock Portfolio in January 2011. In the meantime, you can follow the portfolio here.

      Avg An’l
    Ret Since
    Incep (%)
    Annual Rate of Return (%)
    2009 2008 2007 2006 2005 2004 2003 2002 2001 2000 1999 1998 1997 1996 1995 1994 1993
    Shadow Stock Portfolio 14.2 1.7 72.3 -50.8 -1.8 29.4 17.9 43.7 73.1 10.8 21.4 -7.7 0.0 -8.9 44.3 22.3 20.7 2.0 32.3
    S&P 500 (VFINX) 7.1 -4.7 26.5 -37.0 5.4 15.6 4.8 10.8 28.5 -22.1 -12.0 -9.1 21.1 28.6 33.2 22.9 37.4 1.2 9.9
    Vanguard Small Cap (NAESX) 8.3 -1.3 36.1 -36.0 1.2 15.6 7.4 19.9 45.6 -20.0 3.1 -2.7 23.1 -2.6 24.6 18.1 28.7 -0.5 18.7
    DFA US Micro Cap (DFSCX) 9.9 -0.5 28.1 -36.7 -5.2 16.2 5.7 18.4 60.7 -13.3 22.8 -3.6 29.8 -7.3 22.8 17.6 34.5 3.1 21.0


    Company (Ticker) Reason
    MedCath Corp. (MDTH) negative earnings
    Rex American Resources Corp. (REX)  


    Raymond from oh posted over 6 years ago:

    change state

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