What's UP? AAII's Shadow Stock Portfolio

    by James B. Cloonan

    What's UP? AAII's Shadow Stock Portfolio Splash image

    The Individual Investor’s Shadow Stock Portfolio has had an extremely good year as of this writing in early December (Table 1). By year end, it will most likely have beaten its best previous year, 1997, when it was up 44%.

    Table 1. The Individual Investor’s Shadow Stock Portfolio
      Average Annual Return (%) 1-
    1993-2002 2001-2003* 2003*
    Individual Investor’s Shadow Stock Portfolio 13.3 32.8 65.1 77 80.9
    Vanguard Index 500 Fund (S&P 500) 9 –6.1 22.1 97 22.1

    The S&P 500 index is also up significantly, after its second-worst bearish period in modern times. But then, since World War II, the year preceding an election has always been a strong bull year—up, on average, 22%. The year during the election has also always been up—except for the last election in 2000.

    Web Site Updates

    Before I discuss the Individual Investor’s Shadow Stock Portfolio, I would like to remind you that you can get updated information on both the Individual Investor’s Shadow Stock Portfolio and the Individual Investor’s Mutual Fund Portfolio at our Web site (www.aaii.com; click on Model Portfolios under Tools). Since the AAII Journal has a long production time, when I report current returns here, they really aren’t current by today’s standards. For that reason, we publish monthly updates on our Web site—AAII.com—right after month’s end for both portfolios. The updates include portfolio results as well as recent changes in portfolio composition.

    The AAII Web site also provides the selection rules for each portfolio, so you don’t have to reference previous Journal articles to see how the picks were made. It also includes important concepts I have discussed in AAII Journal articles. I will refer to these concepts from time to time in my column, but won’t have the space for a complete explanation every time I mention them. The most important concept is risk-adjusted return. I discuss this concept and why it so important in the box at left. You can find this explanation later when you need it either by referring back to this issue or visiting the Model Portfolios area of AAII.com.

       Risk-Adjusted Returns
    Throughout the discussions in my column and in my reporting of data, I talk about “risk-adjusted returns.”

    You may well ask: “I got the return I got. What does risk matter?”

    But risk DOES matter. It matters because, if you considered risk, you may have been able to get a higher return. Lower risk is directly exchangeable for higher return unless you are a gambler and not concerned about risk at all.

    There are two ways the exchange of risk for return can take place. Let’s use a simple example to illustrate both approaches. Both of these assume that each individual investor has established a suitable level of risk for their portfolio. Here, risk is measured by standard deviation—the amount by which most actual returns varied around the average return over a period of time; the higher the standard deviation, the greater the volatility of return and, therefore, the greater the risk.

    First Approach: Borrowed Funds
    The first approach uses borrowed funds—margin. Assume that both the market (S&P 500) and Portfolio A have the same expected rate of return: 12%. Also, assume that the S&P 500 has a risk level (standard deviation) of 0.18, while Portfolio A has a risk level (standard deviation) of 0.12. If your suitable risk level is 0.18, then you can simply put 100% of your money in the S&P 500 index and have your return of 12%.

    However, you could also buy 150% of Portfolio A and have a risk level of 0.18—you would put 100% of your own money in Portfolio A, plus you would borrow an additional 50% and put it in Portfolio A. In this case, your return would be 12% on the original investment, plus 3.5% on the additional 50%, for a total return of 15.5% [The additional 3.5% is calculated by taking 50% of the return on Portfolio A less a 5% cost of borrowing: 50%(12% – 5%).]

    In this instance, the lower risk of Portfolio A was directly converted into a higher rate of return by increasing overall portfolio risk through the use of borrowed funds to increase the investment in stock.

    Second Approach: Stocks and Treasuries
    Not everyone is comfortable with margin, and in many cases individual investors do not want the risk level of an all-stock portfolio. In that case we can look at the conversion another way, once again using the S&P 500 and Portfolio A.

    If you invest two-thirds of your portfolio in an S&P 500 index fund returning 12% with a risk of 0.18 and one-third of your portfolio in short-term Treasuries yielding 3%, with a risk level of zero, your portfolio will have a risk level of 0.12 (2/3 of 0.18 plus 1/3 of 0.00) and a return of 9% (2/3 of 12% and 1/3 of 3%).

    However, for that same level of risk, 0.12, you could also invest 100% of your money in Portfolio A, and you will get a 12% return. In this case, adjusting your asset allocation allows you to convert risk reduction into increased returns by investing the portfolio in an all-stock portfolio rather than a mix of stocks and Treasuries.

    Shadow Stocks: New and Improved

    One other item you should note concerns the list of Shadow Stocks that has been carried in the AAII Journal each year. Many members complained that the listing had so many stocks that it was cumbersome and not very useful. For that reason, we are abandoning it for more expanded coverage of the Individual Investor’s Shadow Stock Portfolio. Thirty to 40 stocks should be a more meaningful quantity. We will perform much of the same kind of analysis on the smaller portfolio as we did on the old Shadow Stocks list.

    I have had several questions about the difference between the Shadow Stocks that we previously listed each year in the February AAII Journal, and the new Individual Investor’s Shadow Stock Portfolio.

  • The former was a listing of all stocks that met the original definition of “small cap,” with the elimination of any that were actively traded by institutional investors. This list typically was quite large—usually over 200 stocks—and was designed to provide a starting point for further investigation.

  • The Individual Investor’s Shadow Stock Portfolio was previously named the Beginner’s Portfolio, and it is a listing that includes only micro-cap stocks with low price-to-book-value ratios. The portfolio reflects the research that shows that both value, as measured by the price-to-book-value ratio, and size, as measured by market capitalization, are important determinants of higher-than-average returns.

    Portfolio Changes

    The Individual Investor’s Shadow Stock Portfolio has had several changes since the complete listing appeared in the November 2003 AAII Journal. Additions and sales appear in Table 2.

    Table 2. Individual Investor’s Shadow Stock Portfolio: Update
    ADDITIONS As of 11/28/03
    Company (Exchange: Ticker) Market
    ($ Mil)
    Strategic Distribution (Nasdaq: STRD) 44.3 0.87
    Sands Regent (Nasdaq: SNDS) 20.9 0.56
    WestCoast Hospitality (NYSE: WEH) 63.7 0.51
    Books-a-Million, Inc. (Nasdaq: BAMM) 73.3 0.59
    Lazare Kaplan Int’l (ASE: LKI) 57.6 0.64
    Imperial Parking Corp. (ASE: IPK) 43.3 0.62
    Northwest Pipe Co. (Nasdaq: NWPX) 97.1 0.76
    Stephan Co. (ASE: TSC) 18.9 0.49
    Company (Exchange: Ticker) Reason
    Aviall, Inc. (NYSE: AVL) grown too large
    Garden Fresh Restaruant (Nasdaq: LTUS) bought out
    Ag Services of America (NYSE: ASV) bought out
    Bought and Sold
    Bogen Communications (Nasdaq: BOGN), bought but then sold because of a company tender and planned delisting

    There were other stocks that met most of our purchase criteria, but they were too thinly traded for our portfolio. If you are using the Individual Investor’s Shadow Stock Portfolio criteria either from the November 2003 Journal or as provided in our Stock Investor Pro stock screening software, you may have been able to buy other stocks based on your portfolio size.

    I will update the portfolio again in the April 2004 AAII Journal. For a complete list of the current stocks in the Individual Investor’s Shadow Stock Portfolio, go to www.aaii.com/modelportfolios.

       Model Portfolios on AAII.com
    To access the Individual Investor’s Shadow Stock Portfolio and the Mutual Fund Portfolio, go to www.aaii.com/modelportfolios. The Model Portfolios area includes:
    • Current composition for each portfolio,
    • Monthly performance results for each portfolio,
    • Selection rules for each portfolio, and
    • Explanations of important concepts.
    Updates are posted after each month’s end.

    James B. Cloonan is founder and chairman of AAII.

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