September Model Shadow Stock Portfolio Changes

Following his September quarterly portfolio review, James Cloonan unveiled several new portfolio rules for the Model Shadow Stock Portfolio. These new rules came about from changes in market conditions as well as Cloonan’s research for his book, “Investing at Level3.” The specific changes are:

The maximum market capitalization was raised from $300 million to $400 million. This also means that the new sell threshold for stocks in the portfolio will now be $1.2 billion.
Stocks in the rental & leasing industry classification of Thomson Reuters have been eliminated from the portfolio and will no longer be considered for purchase.
Stocks in the utility sector classification of Thomson Reuters will no longer be considered for purchase.
In order to be considered for the Model Shadow Stock Portfolio, a stock must have relative price strength over the last 26 weeks that ranks in the top half of the stock universe. In other words, the stock’s price must have increased more (or decreased less) relative to the market than the majority of stocks in our database over the last 26 weeks.

In addition,  Cloonan has adjusted the portfolio management rules to permit holding more than 5% in cash. This allows for greater flexibility and patience when making buy decisions for the portfolio.

As a result of these rule changes, as well as updated quarterly earnings, three stocks were removed from the portfolio:

CDI Corp. (CDI) and LMI Aerospace, Inc. (LMIA) were sold because they violated their earnings probation for consecutive quarters.
Willis Lease Finance Corp. (WLFC) was sold because it is in the rental & leasing industry, violating the new rule implemented this month.

Because of the new price momentum rules that Jim Cloonan implemented this month, 14 stocks passed the Individual Investor’s Shadow Stock Screen (*IISSP) in Stock Investor Pro as of of August 31, 2016. [The screen has been updated within the program to reflect the new portfolio selection rules.] This is a decline from the 26 stocks that passed last month.

Of these 14 passing companies, only five stocks met the liquidity requirements for the Model Shadow Stock Portfolio (these requirements will vary depending on the amount of money you are investing). In addition, one company was eliminated because it was primarily based in China and another was eliminated for having too wide of a bid/ask spread. The remaining three companies were added to the Model Shadow Stock Portfolio:

AV Homes Inc. (AVHI)
Beazer Homes USA, Inc. (BZH)
Hallador Energy Co. (HNRG)

Members were alerted about these changes via a special Model Portfolios Update email on September 1, the day Jim Cloonan placed the buy trades, and a posted notice at the Model Portfolios area of AAII.com. In the future, we will inform members of changes to the AAII model portfolios via special email alerts and web notices. Be sure you are signed up to receive these free notices by logging into AAII.com, going to www.aaii.com/email and selecting the Model Portfolios Update email.

For more information on the changes to the Model Shadow Stock Portfolio rules as well as this month’s buys and sells, read Jim Cloonan’s column in the October issue of the AAII Journal.

Four stocks in the actual Model Shadow Stock Portfolio met the revised selection criteria as of the end of August: The three new stocks—AV Homes Inc. (AVHI), Beazer Homes USA (BZH), Hallador Energy Co. (HNRG)—and Salem Media Group (SALM). Qualifying companies are those held in the Model Shadow Stock Portfolio that currently meet the initial purchase rules. (They are designated as “qualified” in the notes column of the Model Shadow Stock Portfolio table.)

No stocks currently in the portfolio are approaching their valuation or size limits. However, one stock is currently on probation for generating negative normalized earnings over the last 12 months (trailing four quarters). Ducommun Incorporated (DCO) has been on probation since reporting its third-quarter 2015 earnings. However, for the subsequent three quarters, the company has reported flat or positive adjusted quarterly earnings. So, although trailing earnings have remained negative, the company has not reported another quarter of negative earnings that would trigger the portfolio’s earnings sell rule.

The next quarterly review of the AAII Model Shadow Stock Portfolio will take place in early December. Any changes to the portfolio will be announced at the time they are made in a special Model Portfolios Update email, as well as highlighted in the December AAII Model Portfolio Update email and in Jim Cloonan’s Model Portfolios column in the January 2017 issue of the AAII Journal.

Click here to see the current purchase and sell rules. The size and value rules are subject to revision depending on prevailing market conditions.

August Month in Review

Investors and traders alike were probably very happy to see how calm August 2016 was compared to a year ago, when China’s currency devaluation and poor liquidity conditions sent global equities tumbling in August 2015. In fact, according to J.P. Morgan Asset Management, last month saw the fourth-narrowest trading range for August since at least 1928 (the range was smaller in 1958, 1964 and 1965). Furthermore, according to Standard & Poor’s, there were 18% fewer shares traded in August than the average for the last 10 Augusts.

For the first half of the month, U.S. equities were driven by generally positive economic news and better-than-expected corporate earnings. As of the end of August, 98% of the S&P 500 companies had reported their second-quarter earnings. Of those that had reported, 71% had beaten earnings expectations and 53% had exceeded revenue expectations, according to Standard & Poor’s. On the economic front, second-quarter GDP was revised downward from 1.2% to 1.1%, but this was in line with expectations. The July jobs report at the beginning of August made a strong positive statement as to the overall condition of the U.S. labor market, both in terms of job creation and wage growth.

In the latter half of the month, volatility took an uptick as the markets started to focus on what actions the Federal Reserve may take during its September 21-22 meeting. Fed chair Janet Yellen gave a glimpse into what may take place with her comments at the annual Jackson Hole Economics Policy Symposium. There, she spoke in positive terms about the U.S. economy, stating that the case for higher interest rates had strengthened in recent months. As a result, the utilities and telecommunications sectors suffered at the end of August, while banks received a boost on the possibility of better margins through higher rates.

While August was relatively calm—the S&P 500 failed to see a single trading day where it moved more than 1% to the upside or downside for the entire month—don’t expect this to last. If the Fed does decide to increase rates, it’s unclear how U.S. markets would react. Furthermore, we are less than two months from the U.S. presidential election and the contest is by no means settled. As a result, the outcome of the election more than likely hasn’t been priced into the U.S. stock market.

Overall in August, small-cap issues outperformed large-cap and mid-cap stocks. On a total return basis, the S&P SmallCap 600 index gained 1.4% in August, compared to a 0.1% return for the S&P 500 and 0.5% for the S&P MidCap 400 index. The relative underperformance of larger stocks was also apparent when looking at the performance of two major equal-weighted ETFs—the Guggenheim S&P 500 Equal Weight ETF (RSP) and the PowerShares Russell 1000 Equal Weight ETF (EQAL). RSP returned 0.2% in August while EQAL fell 0.4% on a total return basis.

Comparing growth- and value-oriented stocks, the results were mixed in August depending on the market-cap segment. In the large-cap space, value was stronger than growth, as the S&P 500 Value index added 0.6% while the S&P 500 Growth index shed 0.3%. However, the reverse was true for mid-caps and small-caps. The S&P MidCap 400 Growth index outperformed its growth counterpart 0.6% to 0.4%, while the S&P SmallCap 600 Growth index was up 1.6% versus a 1.1% gain for the S&P SmallCap 600 Value index.

Interest-rate-sensitive sectors suffered in August on the prospects of rising interest rates. After posting the best sector returns in July, utilities slid 5.6% in August; real estate, the second-best performer in July, fell 3.6% in August. In contrast, financial services and financials were the top performers in August after being at the back of the pack last month. These two sectors were up 5.7% and 3.8%, respectively, for the month.

Model Shadow Stock Portfolio Performance & News

The AAII Model Shadow Stock Portfolio, which is a real-money portfolio of micro-cap value stocks, climbed 2.2% in August. Breadth was neutral for the portfolio, as 16 of the 30 stocks that were in the Model Shadow Stock Portfolio at the end of July were up in August. Seven of the Shadow Stocks posted gains of 15% or more in August, while three saw losses in excess of 15%. Overall, the Model Shadow Stock Portfolio outperformed the DFA U.S. Micro Cap Fund (DFSCX), which was up 1.6% in August.

Alamo Group, Inc. (ALG) announced results for its second quarter ended June 30, 2016. Net income for the quarter was $10.6 million, or $0.92 per diluted share, compared to net income of $9.7 million, or $0.84 per diluted share, in 2015. The I/B/E/S consensus estimate for the quarter was $0.997 per share, representing a 7.7% negative surprise.
CDI Corp. (CDI) reported results for the second quarter ended June 30, 2016. For the quarter, revenue decreased by $20.1 million or 8.2% (7.0% in constant currency) compared to a year ago. The company reported an operating loss in the second quarter of $6.5 million compared to an operating profit of $1.2 million a year ago. The second-quarter net loss attributable to CDI was $7.5 million, or $0.39 per diluted share, versus a net loss of $0.2 million, or $0.01 per diluted share, a year ago. The adjusted loss per diluted share was $0.33 in the second quarter versus adjusted earnings per diluted share of $0.00 a year ago. This fell short of the consensus estimate for the quarter by 32%. (CDI was sold because it violated its earnings probation for consecutive quarters.)
CSS Industries Inc. (CSS) reported results for its first quarter of fiscal 2017 ended June 30, 2016. Sales for the quarter increased 2.5%, to $45.3 million, from $44.2 million a year ago. The company reported a net loss of $3.2 million, or $0.36 per diluted share, for the quarter, compared to a net loss of $3.1 million, or $0.33 per diluted share, a year ago.
Ducommun Inc. (DCO) reported results for its second quarter ended July 2, 2016. Revenue for the quarter was $133.4 million, a decrease compared to revenue of $174.8 a year ago. Net income was $3.9 million, or $0.34 per diluted share, compared to net income of $1.8 million, or $0.16 per diluted share, a year ago. This was a 19.7% positive surprise over the I/B/E/S consensus earnings estimate of $0.284 per share.
Flexsteel Industries Inc. (FLXS) announced results for its fourth quarter and fiscal year, reporting a 7.1% increase in net sales to $500 million for the year. For the quarter, the company reported net sales of $123 million compared to $121 million a year ago. Net income in the fourth quarter was $6.2 million, or $0.78 per diluted share, compared to $5.8 million, or $0.74 per diluted share, a year ago.
Global Power Equipment (GLPW) has undertaken several initiatives to restructure its operations, lower its operating costs and reduce indebtedness. The company sold the stock of TOG Holdings, Inc., a wholly owned subsidiary, for $6 million in cash to Doncasters Group. Proceeds from the sale of TOG will go toward reducing indebtedness. The company is also in the process of selling its Braden Mexico facilities, an approximate 150,000 square foot manufacturing facility that had supported fabrication of auxiliary equipment for utility-scale natural gas turbines. The manufacturing that had historically occurred at Braden Mexico will be consolidated into the company’s global network of outsource manufacturing partners. In addition, the company is evaluating other real estate assets for potential sale to enable further debt reduction.
Hardinge Inc. (HDNG) released its financial results for its second quarter ended June 30, 2016. Net sales for the quarter were $0.2 million, down 15% from $82.4 million a year ago. Excluding the impact of unfavorable foreign currency translation, sales were down 13%. Second-quarter net income was $0.1 million, or $0.01 per diluted share, compared to $1.6 million, or $0.12 per diluted share, a year ago. Hardinge failed to beat the I/B/E/S consensus earnings estimate, which was $0.06 per share.
Kimball Electronics Inc. (KE) posted its fourth quarter and fiscal year results for 2016. Quarterly net sales were $220.4 million, up from $201.1 million a year ago. Non-GAAP adjusted net income was $5.8 million, or $0.20 per diluted share, a decline from $7.4 million, or $0.25 per diluted share, a year ago. This fell short of the I/B/E/S consensus estimate for the quarter of $0.21.
LMI Aerospace Inc. (LMIA) announced its financial results for the second quarter ended June 30, 2016. For the second quarter of 2016, net sales were $84.0 million, compared to $97.6 million a year ago. A net loss of $29.9 million, or $2.28 per diluted share, was realized in the second quarter of 2016, compared to net income of $0.4 million, or $0.03 per diluted share, in the second quarter of 2015. This was 402% below the consensus estimate for the quarter of earnings of $0.04 per share. (LMIA was sold because it violated its earnings probation for consecutive quarters.)
RCM Technologies (RCMT) reported second-quarter 2016 net income of $0.9 million, or $0.07 per diluted share, 40% above the same period a year ago. Second-quarter revenue grew 0.2%, to $45.4 million, from a year ago. Operating income was $1.5 million for the quarter, a 26.3% increase as compared to $1.2 million a year ago.
Renewable Energy Group (REGI) reported second-quarter 2016 net income of $6.9 million, or $0.16 per diluted share, a 420% increase from a year ago but below the I/B/E/S consensus estimate of $0.21 per share. Second-quarter revenue grew 49.4%, to $558.3 million, from a year ago.
REX American Resources (REX) reported second-quarter 2016 net income of $8.2 million, or $1.24 per diluted share, 43% below the same period a year ago but above the I/B/E/S estimate of $1.11 per share. Second-quarter revenue grew 1.9%, to $115.7 million, compared to a year ago.
Salem Media Group Inc. (SALM) reported second-quarter 2016 adjusted net income $3.4 million, or $0.13 per diluted share, a 5% decline from a year ago but above the I/B/E/S consensus estimate of $0.10 per share. Second quarter revenue increased 1%, to $67.8 million, from a year ago.
Shoe Carnival, Inc. (SCVL) reported second-quarter 2016 net earnings of $4.1 million, or $0.22 per diluted share, down 8.3% from a year ago and below the I/B/E/S consensus estimate of $0.268 per share. Net sales increased 1.8% year over year, to $231.9 million for the quarter. Comparable store sales increased 0.5% during the quarter. Looking forward, the company reaffirmed its earnings per share guidance to be in the range of $1.58 to $1.65. Shoe Carnival also narrowed its revenue guidance, now forecasted to be between $1.012 billion and $1.016 billion for the year.
Townsquare Media Inc. (TSQ) reported second-quarter adjusted earnings of $0.22 per share, a 57.7% decline from a year ago and below the I/B/E/S consensus estimate of $0.23 per share. Second-quarter revenue increased 16.7%, to $137.2 million, compared to a year ago. In addition, The Madison Square Garden Company (MSG) announced that it has acquired approximately 3.2 million shares of Townsquare Media, representing a 12% common equity stake. MSG and Townsquare will seek to utilize their shared experience in music and live events to explore bookings, sponsorships, and marketing opportunities, as well as the potential expansion of Townsquare’s live offerings. Townsquare did not receive any proceeds from this transaction. The stock was purchased as Class C, but immediately converted to Class A shares upon the closing of the transaction.
TravelCenters of America LLC (TA) announced financial results for the 2016 second quarter. Second-quarter adjusted earnings per share were $0.09, down 10% from a year ago and below the I/B/E/S consensus estimate of $0.19. Second-quarter revenue fell 8.7% year over year to $1.45 billion.
Vishay Precision Group (VPG) reported adjusted earnings per share of $0.15 for the second quarter, a 15.4% increase from a year ago but below the I/B/E/S consensus estimate of $0.20. Second-quarter revenue fell 2.5% year over year to $58 million. Looking forward, the company issued guidance for the third quarter, forecasting revenues to be in the range of $55 million to $60 million. The Vishay Precision Group also lowered its guidance on full-year 2016 earnings per share from $0.80 to $1.00 down to $0.70 to $0.80.

It is also worth pointing out that PC Connection, Inc. has changed its brand name to Connection. The company began trading under the new ticker symbol CNXN at the market open on Friday, September 9, 2016.

Year-to-date, the AAII Model Shadow Stock Portfolio is up 11.8%, compared to the S&P 500 large-cap index, as represented by the Vanguard S&P 500 index fund (VFINX), which is up 7.7%. The DFA U.S. Micro Cap Fund (DFSCX) is up 9.8% for the year through the end of August.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.5% versus the S&P 500 index fund, which has gained, on average, 9.0% a year over the same period.

September Model Fund Portfolio Updates

The AAII Model Fund Portfolio lost 0.26% in August, compared to a 0.13% total return for the SPDR S&P 500 ETF (SPY). The Model Fund Portfolio has gained 8.8% year to date, while the SPDR S&P 500 ETF is up 7.7%. Since its inception in June of 2003, the Model Fund Portfolio has a compounded annual average return of 8.4%, which slightly lags the 8.7% average annual return of the SPDR ETF over the same period.

There are no changes in the holdings of the Model Fund Portfolio this month. The next portfolio quarterly review will occur in October and Jim Cloonan will discuss it in his column in the November AAII Journal. He will also further discuss the new Level3 Portfolio in that column.

Click here to learn about how the current mutual funds and exchange-traded funds (ETFs) in the AAII Model Fund Portfolio were chosen.