Shadow Stock Portfolio Still Leads as Market Runs Out of Gas

    by James B. Cloonan

    Shadow Stock Portfolio Still Leads As Market Runs Out Of Gas Splash image

    It is always satisfying to see your holdings zoom off at a torrid pace, wheels screeching and competitors in the dust.

    The only problem, however, comes down the road, when the portfolio inevitably runs out of gas.

    I warned about this in my review of the Model Shadow Stock Portfolio in the April 2005 AAII Journal [posted as Commentary at the Shadow Stock Portfolio page of]. At that time, it had clocked a 33% return over the prior six-month period.

    Well, we are now six months down the road. And sure enough, the Model Shadow Stock Portfolio is starting to run on fumes alone. During the last three months (through the end of May), the portfolio ran in reverse—it was down over 6.5%. However, calendar-year 2005 to date, it is down 1.1%.

    Figure 1.
    Model Shadow
    Stock Portfolio
    vs. Benchmarks
    (Through 5/31/05)

    Fortunately for the Model Shadow Stock Portfolio, it is a market-wide gas shortage. The Model Stock Portfolio’s year-to-date figure is just about dead even with the S&P 500’s year-to-date figure of –1.0%, and better than the –2.5% for small-cap stocks.

    The returns for various periods can be seen in Figure 1. It certainly helps to have a head start.

    The year through May has been an up-and-down-sideways affair and not the strong up year that historically occurs in years ending in 5. However, the year is not over and there are some signs of market strength. But uncertainty about the economy, interest rates, and oil prices will continue to make the market volatile.

    Portfolio Activity

    Table 1 shows the current list of stocks in the Model Shadow Stock Portfolio.

    There was activity in the portfolio in May, with four sales and three additions, as highlighted in Table 2.

    Several of the trades had unusual aspects which are worth noting.

    TABLE 2. Model Shadow Stock Portfolio 2005 Transactions
    Company (Ticker) Reason
    2005 First Quarter
    Chronimed (CHMD) and MIM Corp. merged to form BioScrip (BIOS)  
    2005 Second Quarter
    Stock Split  
    Zapata Corporation (ZAP) distributed an 8-for-1 stock split  
    Dura Automotive Systems (DRRA) negative earnings
    Quaker Fabric Corp. (QFAB) negative earnings
    AirNet Systems, Inc. (ANS) negative earnings
    Action Performance Companies (ATN) negative earnings
    Finlay Enterprises, Inc. (FNLY)  
    GenTek Inc. (GETI)  
    Five Star Quality Care, Inc. (FVE)  

    Dura Automotive Systems (DRRA)
    Dura Automotive was sold without ever having been on probation. This resulted from a restatement of earnings, which created both a down year and a following down quarter all at once. Those of you who update your portfolio more often than once a quarter may have dumped DRRA even earlier.

    Finlay Enterprises (FNLY) and GenTek (GETI)
    Two of our buys—Finlay Enterprises Inc. and GenTek Inc.—came out with negative quarterly earnings shortly after we bought them. GenTek immediately went down.

    Finlay Enterprises is particularly interesting because it makes a profit every year, but all of it is in the fourth (holiday) quarter. Under our Model Stock Portfolio rules, it would only qualify after the fourth-quarter earnings report and before the first-quarter earnings report each year. Since neither of these two stocks would qualify under the rules if they were being screened right now, I will leave it up to you whether to buy them or not.

    I would suggest buying Finlay Enterprises anyway because it meets the spirit of our approach, even if the nature of its business only qualifies it after fourth-quarter earnings.

    Metals USA (MUSA)
    We also have a buyout pending. Metals USA, which was approaching our size limit, is being bought out by Apollo Management for $22.00 a share. Since the Model Shadow Stock Portfolio is still holding the stock, I thought this would be a good time to look at the question of what to do with a tender offer that has been approved by the board of the target company.

    The Model Shadow Stock Portfolio rules say that in this situation, you should use your best judgment. My own usual approach is to sell the stock at the next quarterly portfolio adjustment. However, if—as in this case—I do not have another stock on my buy list, I will wait for the actual buyout and pick up the current discount from the buyout price, which is almost always higher than the interest rate from a stock broker.

    The Two-Year Rule

    We are providing the Model Shadow Stock Portfolio rules again this issue (Table 3), and I want to emphasize the meaning of our two-year rule (which appears under the “Stocks are sold” section of the Purchase and Sales Rules).

      TABLE 3. Model Shadow Stock Portfolio Rules
    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. (This figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $17 million and $200 million. (This 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 foreign stocks 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 first item under stock order rules concerning spreads when buying shares.
    • Price-to-sales ratio must be less than 1.2. (This 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 2½ times the initial criterion.
    • Market capitalization goes above 2½ times the initial maximum criterion.
    • After two years, sell if not qualifying as a buy currently. (But do not sell until there is a qualified stock to buy.)
    Stock Order Rules
    • If the quoted bid-ask spread is more than 4% (ask price minus bid price, divided by ask price), the stock is eliminated from consideration. Better to stretch other criteria, if necessary, than pay high spreads.
    • Stocks are eliminated if the average daily number of shares traded is not four times the amount needed for the position—the spread will be too high and not negotiable either now or when sold.
    • Market orders are not used. Instead, orders are placed between the bid and ask prices unless the difference between the two is 2% or less, in which case purchases are placed at the ask price and sales are placed at the bid price.
    • 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.
    • All order rules can be adjusted based on your own judgment and experience.
    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 early 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. More than 20 stocks is not needed until the portfolio exceeds $1 million.

    If we have held a stock two years and it no longer qualifies, we will sell it in order to buy a stock that does qualify—if there is one. The stock we sell may be a perfectly good stock and may have a profit, but we believe that a newly qualifying stock has a better chance for appreciation. This rule is meant only for portfolios in which you do not want to expand the number of holdings—in other words, where you can only buy a stock if you sell a stock to free up cash for the purchase.

    For those who are adding cash to the portfolio, there is no need to sell stocks after two years as long as you have funds for the new purchases. Our actual portfolio is limited to the funds in it, so we must sell to buy. When the time comes, we will indicate any sells that are driven by the two-year rule.

    Finding Qualifiers

    I have had several inquiries indicating difficulty in finding qualifying stocks.

    We are looking for very special stocks and it will require a bit of patience to build a portfolio. You may want to stretch the criteria a little, which is fine. If the market starts to rise, we may have to adjust the official criteria.

    If it is the bid/ask spread rule that is creating problems for you, try placing limit orders in between the bid and ask, and be willing to build the desired position in stages.

    Monthly Updates at

    I will be reviewing the portfolio here in the AAII Journal in another three months. However, information on this portfolio is updated monthly at our Web site:

    This year has been rather unusual in terms of the timing of the ups and downs. Perhaps the summer, which is usually lackluster, will also surprise us.

    James B. Cloonan is founder and chairman of AAII.

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