Shadow Stock Portfolio: Still Up for the Year After Market Correction

    by James B. Cloonan

    The stock market adjustment that began in late May hurt the Model Shadow Stock Portfolio, but as of May 31 it was still up 11.4% for the year as compared to 2.5% for the Vanguard 500 Index fund (VFINX). Figure 1 shows the comparisons for other periods and indexes. For well over a year now pundits have been saying the time for small cap and value is about to end, and we should all switch to large-cap growth. However, large-cap growth year-to-date through May 31 is down 0.4%, as measured by Vanguard’s Growth Index fund (VIGRX, not shown).

    Some year, no doubt, large cap and growth will be winners. But I would hang with small cap and value even though they will occasionally have a poor year.

    Just as a refresher—the Model Shadow Stock Portfolio provides guidance for investing in the promising micro-cap value sector of the market. It reflects my investing philosophy, which holds that:

    • The best stocks for individual investors are not the same stocks that are best for institutions;
    • Ultimately, the best returns come from giving major consideration to risk; and
    • Success comes more from concern for the overall portfolio than concern for individual stocks.
    The Model Shadow Stock Portfolio is an actual portfolio with real dollars invested, and updates on portfolio activity are provided both in the AAII Journal in this column, and at on our Web site (

    Quarterly Portfolio Activity

    Table 1 highlights the activity during June, and Table 2 shows the current holdings and their status in the portfolio.

    GenTek (GETI) was sold because it had gone over the value limit.

    Marsh Supermarkets (MARSA/B) was sold because the board has agreed to sell out. There are competing offers and since the current price is higher than the offer the board is currently supporting, we sold.

    Stephan Co. (TSC) and Zapata (ZAP) were sold for violating the earnings probation rules.

    We added Avalon Holdings Corp. (AWX) and Handelman Co. (HDL) to the portfolio.

    There have been no rule changes this month; the full set of rules is presented on page 30.

    The next Model Portfolios column will be in the August AAII Journal and will cover the Model Mutual Fund Portfolio.

    Monthly updates of both the Shadow Stock and Mutual Fund Portfolios can be found at along with their past histories and rules.

    Figure 1.
    Model Shadow Stock
    Portfolio vs. Benchmarks
    (Through 5/31/06)

    Table 1. Second-Quarter 2006 Transactions
    Company (Ticker) Reason
    GenTek Inc. (GETI) exceeded value limits
    Marsh Supermarkets (MARSA/B) buyout pending
    The Stephan Co. (TSC) negative earnings
    Zapata Corp. (ZAP) negative earnings
    Avalon Holdings Corp. (AWX)
    Handelman Co. (HDL)


    The Outlook

    While I have no idea where the market is going from here, I believe that small caps and value are still the place to be.

    The downturn that began toward the end of May seemed unusual, but so did the strong market earlier in the year.

    In the yearly patterns based on election cycles, this year is generally not a strong year. However, next year—the year before the presidential election—is typically the strongest, averaging +22.7% and never negative since 1931.

    I will discuss this further in my column in the October AAII Journal with the next Shadow Stock Portfolio review.

       Analyzing Your Portfolio Risk On-Line

    To measure the overall risk of your portfolio and the effectiveness of your diversification, go to the RiskGrades Web site ( You can enter your entire portfolio—including stocks, bonds and mutual funds—and determine its risk and its diversification efficiency. You can also compare it to several indexes in terms of performance and risk. And you can determine the amount of return per unit of risk, to see if you are being compensated enough for the level of risk you have taken on.

    RiskGrades uses standard deviation as the basis for its risk measurement, but makes it more meaningful through standardization—it takes the average of all the world’s equities, and assigns it a standard deviation of 100. All other standard deviations are expressed as a percentage of that figure. For example, a portfolio RiskGrade of 77 implies it has a risk 77% as high as the average risk of all equities in the world.

    The RiskGrades Web site provides the mathematical details of the approach, and it is free of charge for individual investors.

       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 three times the initial criterion.
    • Market capitalization goes above three 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.

→ James B. Cloonan