The Model Shadow Stock Portfolio and Micro-Cap Stock Spreads

by James B. Cloonan

The Model Shadow Stock Portfolio And Micro Cap Stock Spreads Splash image

Even with the pullback in August, it continues to be a very strong year for the Model Shadow Stock Portfolio. The portfolio is up 33.6% year-to-date as of August 31, 2013, compared to a gain of 16.0% for the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX).

These results, as well as results for longer periods, can be seen in Figure 1 and Table 3. Almost every segment of the stock market seems very strong despite lots of disquieting events. I mentioned last quarter that although some of the economic concerns had lessened, we would probably find a new problem by the time this article was written. Sure enough, we got Syria and the problem of how to respond to their use of chemical weapons.

While the decision of what to do about Syria will be made before my January column, the budget crisis will be coming back into play over the next three months. So far, the market has taken a little step back with each negative event or prediction and then come bouncing back.

Interest rates keep going up. While this mainly affects bonds, there is an impact on those stocks whose price levels are maintained based on dividend yield. The Model Shadow Stock Portfolio does not include any such stocks. There is some feeling that as interest rates rise investors will switch from stocks to bonds, thereby putting downward pressure on stock prices. Interest rate increases, particularly at current low levels, are likely to signal continued economic recovery, which should be positive for stocks.

Portfolio Changes

Table 1 lists the current holdings in the Model Shadow Stock Portfolio. We sold Saga Communications Inc.(SGA) because it no longer comes close to being a value stock. It may prosper in someone’s growth portfolio. The August pullback stopped Standard Motor Products (SMP) from breaking through the value or size limits, but it is quite close.

As shown in Figure 2, we were down to seven qualifying stocks this quarter using the liquidity requirements as described in the portfolio rules. We already owned three of the stocks. Two were Chinese, which we avoid, and we bought the other two.

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With the proceeds from selling SGA, we purchased Fab Universal Corp. (FU) and LMI Aerospace Inc. (LMIA). The summary of actions can be seen in Table 2.


I receive quite a few questions about spread, which is the difference between the bid and ask (offer) prices. The spreads on many micro-cap stocks are quite high. To a certain extent, the high spreads and lack of liquidity are why we get paid higher returns, but reducing the spread effect is still desirable. A 5% or higher spread digs into the eventual return significantly. The results that the Model Shadow Stock Portfolio has achieved over the years were accomplished while paying high spreads, but we do try to reduce the impact.

Company Reason
Fab Universal Corp. (FU)  
LMI Aerospace, Inc. (LMIA)  
Saga Communications, Inc. (SGA) exceeded value limit

The most important approach to reducing the negative impact of the spread is to minimize turnover. Our turnover ratio for the past 12 months was 13%, which really helps. This is why whenever there is a close decision about selling a stock, I avoid the transaction. When there are numerous stocks that qualify for purchase, the lower spread becomes a major tie-breaker.

There are also approaches to take when executing trades. It is important to realize that after you have done all the things recommended above, you still must pay a spread. Market makers are not going to make an efficient market without compensation that relates to the stock’s liquidity. If you place a buy order at a price between the bid and ask, there is a small chance that another investor will do the same thing on the sell side of the trade before the market moves. Generally, however, when you get an execution between the bid and ask it means that the market moved and you paid the new spread. If the market moved in the opposite direction, you won’t get a fill and may have to pay more than the old ask.

  Average Annual Return (%) Cumulative Value of $10,000 ($)
  Model Vanguard Vanguard Model Vanguard Vanguard
  Shadow 500 Small Cap Shadow 500 Small Cap
  Stock  Index Index Stock  Index Index
Year Portfolio (VFINX) (NAESX) Portfolio (VFINX) (NAESX)
1993 32.3 9.9 18.7 13,230 10,989 11,870
1994 2.0 1.2 -0.5 13,492 11,118 11,810
1995 20.7 37.4 28.7 16,291 15,282 15,204
1996 22.3 22.9 18.1 19,927 18,775 17,959
1997 44.3 33.2 24.6 28,756 25,010 22,375
1998 -8.9 28.6 -2.6 26,188 32,168 21,790
1999 0.0 21.1 23.1 26,187 38,945 26,831
2000 -7.7 -9.1 -2.7 24,163 35,418 26,116
2001 21.4 -12.0 3.1 29,325 31,160 26,926
2002 10.8 -22.1 -20.0 32,506 24,259 21,535
2003 73.1 28.5 45.6 56,268 31,174 31,360
2004 43.7 10.8 19.9 80,843 34,530 37,587
2005 17.9 4.8 7.4 95,353 36,180 40,376
2006 29.4 15.6 15.6 123,363 41,832 46,687
2007 -1.8 5.4 1.2 121,166 44,083 47,227
2008 -50.8 -37.0 -36.0 59,582 27,764 30,217
2009 72.3 26.5 36.1 102,665 35,120 41,130
2010 45.4 14.9 27.7 149,238 40,358 52,529
2011 6.3 2.0 -2.8 158,701 41,155 51,067
2012 33.3 15.8 18.0 211,588 47,666 60,274
YTD 33.6 16.0 19.7 282,712 55,315 72,153
Since Incep 17.6 8.6 10.0 282,712 55,315 72,153
Data as of 8/31/2013.

Given that you must pay a spread, most of the time you don’t want to give anyone a free lunch. Never enter a market order. If you are willing to pay the ask price, and that is often wise, use that price as your limit price. A market order to buy is likely to get you 100 shares at the offer price and subsequently higher prices for additional shares. Also, you should have patience. Commissions are so low that it is often wiser to place multiple orders over time than a larger trade all at once.

Looking Ahead

We will see another earnings season before my next column, and this should impact stock prices more than most world events. General feelings about longer-term earnings also count, but they are strongly influenced, for right or wrong, by the most recent earnings trend.

President Obama’s choice of a new Federal Reserve chairman should take place soon and will have a short-term impact on interest rates and the stock market. The impact will be based on assumptions about future quantitative easing under the likely candidates. I hope it will be resolved before my next Model Shadow Stock Portfolio column in January 2014. In the meantime, you can follow portfolio news here.

  Current 52-Week Market P/E P/B Div  
  Price High Low Cap Ratio Ratio Yield  
Company (Ticker) ($) ($) ($) ($ Mil) (X) (X) (%) Notes
Addus Homecare Corp. (ADUS) 21.18 23.71 4.70 231.1 21.0 2.07 0.0 approaching value limit
Alamo Group, Inc. (ALG) 45.36 47.61 28.59 549.2 17.4 1.69 0.6  
Alpha & Omega Semicon (AOSL) 7.08 9.90 6.64 180.6 nmf 0.64 0.0 earnings probation (2013 Q4)
CSS Industries Inc. (CSS) 21.82 31.50 18.79 207.6 14.2 0.85 2.7  
Ducommun Incorporated (DCO) 26.15 29.37 12.86 279.3 15.8 1.19 0.0  
Ennis, Inc. (EBF) 17.81 19.42 13.90 466.9 15.8 1.25 3.9  
Fab Universal Corp. (FU)* 4.04 5.70 2.25 84.1 16.2 0.58 0.0 qualified as of 8/31/2013
Flexsteel Industries (FLXS) 22.49 26.29 18.56 159.9 12.6 1.06 2.7  
Gilat Satellite Networks (GILT) 4.75 6.20 3.06 199.6 nmf 0.84 0.0  
Hardinge Inc. (HDNG) 14.49 16.88 8.56 170.4 12.1 1.06 0.6  
Hooker Furniture Corp. (HOFT) 14.39 18.31 11.35 154.5 16.0 1.17 2.8  
International Shipholding (ISH) 23.85 28.13 13.00 172.9 10.8 0.60 4.2 qualified as of 8/31/2013
Key Tronic Corp. (KTCC) 9.91 12.28 8.69 103.9 8.6 1.10 0.0  
Kimball International (KBALB) 9.84 13.25 8.48 294.5 18.9 0.93 2.0  
LMI Aerospace, Inc. (LMIA)* 12.09 23.20 12.02 155.4 11.3 0.73 0.0 qualified as of 8/31/2013
Marlin Business Services (MRLN) 24.36 25.97 15.43 314.8 20.6 1.66 1.8  
Medical Action Industries (MDCI) 5.11 10.07 2.25 83.8 nmf 0.88 0.0  
Mitcham Industries, Inc. (MIND) 17.56 18.79 11.51 224.5 15.7 1.25 0.0  
Olympic Steel, Inc. (ZEUS) 25.98 29.48 15.43 284.5 nmf 0.96 0.3  
PC Connection, Inc. (PCCC) 14.85 17.65 9.82 388.5 11.6 1.26 0.0  
PCM Inc. (PCMI) 9.79 11.96 5.06 113.2 13.8 0.93 0.0  
RCM Technologies, Inc. (RCMT) 5.70 6.72 5.00 70.5 17.3 1.14 0.0  
Renewable Energy Group (REGI) 15.45 16.50 4.28 517.5 9.6 1.15 0.0  
REX American Resources (REX) 29.54 41.00 14.43 241.2 NA 0.96 0.0  
Rocky Brands, Inc. (RCKY) 15.89 19.37 10.84 119.4 11.3 0.94 2.5  
Salem Communications (SALM) 7.74 10.14 4.62 192.0 nmf 1.00 2.6 earnings probation (2013 Q1)
Shoe Carnival, Inc. (SCVL) 25.39 27.22 18.80 519.7 16.8 1.65 0.9  
Standard Motor Products (SMP) 30.66 38.05 16.57 704.9 14.2 2.13 1.4 approaching size & value limits
TravelCenters of America (TA) 7.61 12.50 4.18 225.0 10.9 0.59 0.0 qualified as of 8/31/2013
VOXX International (VOXX) 12.16 15.00 5.55 292.1 9.9 0.65 0.0  
Willis Lease Finance (WLFC) 14.04 16.28 11.70 124.4 40.1 0.54 0.0 qualified as of 8/31/2013
*Company is new to the portfolio. Added 9/3/2013.
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 8/31/2013.
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 $240 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $600 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.

Earnings Probation: If the 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.


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. (Figure will change gradually with changes in overall market values.)
  • Market capitalization must be between $30 million and $240 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.)
  • Eliminate any company that failed to file a 10-Q (quarterly) report in the last six months.

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.

  • The average daily dollar volume should be at least four times the amount needed for your position. This will ensure liquidity to get in and out of the position, even if you need to grow the position gradually and sell gradually. This will result in a varying number of qualifying stocks for each investor.

  • 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.
James B. Cloonan is founder and chairman of AAII.


Norman Kulczyk from NY posted over 2 years ago:

Presently, I hold Alamo which has been a winner.
I also have shares in Ennis, Kimball, and
Standard. I tend to invest in dividend paying
companies. Over the years I sold a number of
shares from the group, and I have shown profits.

As I recall I only one stock a number of years ago at a small loss. I have been a AAII for a number of years.

William Voss from OH posted over 2 years ago:

I am a new member and would like to know the best way to get started, with the 30 stocks suggested in the model shadow stock portfolio is it best to buy a small position in all the suggested positions or is there method of selecting 10 or 12 positions an still be diversified , William Voss

George Feldman from PA posted over 2 years ago:

There is some evidence that FU has committed fraud in its accounting. would anyone like to comment

Charles Rotblut from IL posted over 2 years ago:


The company says there is misinformation about it being spread. Here is an article in the Pittsburgh Post-Gazette:


Kirit Shah from CA posted over 2 years ago:

I would like to know how and when to start
to buy stock of model portfolios,
Please guide me.
Thank you

Thomas Adams from VA posted over 2 years ago:

I have been with AAII for over 4 years and couldn't be happier. I buy stocks on perhaps the worst of all possible systems: intuition. I am by nature a scientist, so I know the fallacy of allowing emotional attachment to inform decisions.
This is why AAII has been so valuable to me. I typically own 4 or 5 of the shadow stocks. With the minor exception of BAM, held too briefly, ALL of the shadows have shown above average profitability. Why only 35% of my portfolio is in AAII stocks reflects my fear of straying too far from so-called "conventional wisdom".
I cannot help but wonder if other readers/staff have the same fear and maintain a substantial position in large cap blue chip stocks(like Wells Fargo, Walmart, AT&T, etc.)?
Keep up the good work and thanks for your unselfish attention to the (little guy) individual investor.
Tom Adams
Richmond, Va.

Charles Rotblut from IL posted over 2 years ago:

Hi Kirit,

You want to buy stocks that are listed as being "qualified." These are stocks that are held within the portfolio and currently meet the buy rules.

We suggest dividing the amount of money you are considering allocating to the Shadow Stock portfolio by the number of Shadow Stocks you intend to purchase. For example, if you plan on allocating $20,000 to buy 10 stocks, you would spend $2,000 on each stock.

If there are fewer than 10 stocks listed as being qualified, buy only those that do qualify and keep the remainder of your money in cash. Then next month, on or after the 15th, check to see if any new stocks are listed as being qualified. Continue doing this until you are fully invested.


Boyd from Washington posted over 2 years ago:

I would like to do some back testing on some Piotroski High F-Score stocks.

How can I get, or where can I go to get the Piotroski High F stock picks for 2012?

R Kraft from NE posted over 2 years ago:

I have been investing using the Shadow Stock Portfolio for about a year and a half. It has excellent results for that time, but over the long haul also when I look at the charts. I continue to invest in the stocks, realizing if the market goes sharply down, so will these stocks (but so do almost all of them in that situation). Thank you for providing this way of investing. I don't know of a better investment, do you?

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