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Model Shadow Stock Portfolio FAQs

SITE MECHANICS

> What is the difference between the Model Shadow Stock Portfolio and the Actual Shadow Stock Portfolio?
>Can I see what stocks have been added to and removed from the actual Shadow Stock Portfolio?
>Why aren't all of the Passing Companies part of the Actual Portfolio?
>When is the Passing Companies list updated?
>Why don't you show the actual portfolio with dates, prices bought and sold, and quantities?

IMPLEMENTING THE PORTFOLIO

> Is the Shadow Stock Portfolio included in AAII's Stock Investor Pro screening software?
> The model portfolio is only updated once a quarter. If I make a purchase between quarters and then because of a change in the stock the model portfolio does not buy the same issue how do I know what to do with the stock in future?
> It seems that many of the stocks qualify because they are in a price downtrend. Isn't that contrary to momentum theory?
>The rules suggest investing in at least 10 stocks, but how do I choose the 10 stocks?
>If there are more than enough stocks on the qualified list should I choose by trying to diversify by industry?
>If I invested only $10,000 per stock that would amount to a substantial portion (1% to 35%) of the stock's average trading volume. It seems to me that this may have a substantial effect on the market for a stock when I went to buy and, more importantly, to sell. Do you have any suggestions?
>Often it is difficult to get executions at the recommended spreads. What to do?
>Is there a brokerage firm that AAII would recommend for the Shadow Stock Portfolio?
>If a stock starts to move up as I buy it, how high can I let it go?
>Does AAII or some other company track the Shadow Stock Portfolio as a mutual fund?

PORTFOLIO MANAGEMENT ISSUES

> I bought two stocks based on the Shadow Stock recommendations. Now, I cannot find them either in the Actual Portfolio or in the Transaction History. Why is this?
>Four of my holdings have lost money since I purchased them. Your sell rules do not cover sale of stock at some level of loss to protect overall portfolio returns. Do you have guidance?
>Should I rebalance my holdings?
>Should dividends be reinvested when using the Shadow Stock Portfolio?
>How do you handle proposed buyouts in the Shadow Stock Portfolio?
>If a company I hold is bought out by another company for stock should I hold that stock?
>What should I do if a stock I hold is delisted?

Site Mechanics

What is the difference between the Model Shadow Stock Portfolio and the Actual Shadow Stock Portfolio?

The Model Shadow Stock Portfolio refers to the concept, the list of rules for managing a portfolio of small-cap value stocks. The Actual Portfolio is the list of stocks that are actually being held based on carrying out the management rules; It is used to calculate the performance of the Shadow Stock Portfolio. The list we run in the Journal that is labeled the Model Shadow Stock Portfolio is the Actual Portfolio. On the website, we call it the Actual Portfolio to distinguish it from the Passing Companies—a list of stocks that pass the purchase rules that is updated each month for members' use.

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Can I see what stocks have been added to and removed from the Actual Shadow Stock Portfolio?

Changes are made to the Actual Portfolio four times a year. The Transaction History link shows the stocks that have been bought and sold each quarter along with the date. Changes are also reported in the AAII Journal in the January, April, July and October issues.

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Why aren't all of the Passing Companies part of the Actual Portfolio?

The Actual Portfolio is reviewed four times a year (see the Transaction History). At that time, if any stocks meet the portfolio's sell rules, they are sold and new qualifying stocks are purchased with the proceeds. The Passing Companies list, on the other hand, is simply a list of all the stocks that meet the purchase rules, and it is updated each month on-line. Many members use the Passing Companies list as a starting point for building their own Shadow Stock Portfolios.

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When is the Passing Companies list updated?

A new list of Passing Companies is posted each month in the middle of the month, usually with data as of the previous month-end.

Why don't you show the Actual Portfolio with dates, prices bought and sold, and quantities?

This is not intended as an advisory letter but as a learning tool. Those details do not enter the decision process and would just make everything harder to understand.

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Implementing the Portfolio

Is the Shadow Stock Portfolio included in AAII's Stock Investor Pro screening software?

Yes, subscribers to AAII Stock Investor Pro can run the Shadow Stock screen by choosing *IISSP from the list of preprogrammed screens.

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The model portfolio is only updated once a quarter. If I make a purchase between quarters and then because of a change in the stock the model portfolio does not buy the same issue how do I know what to do with the stock in the future?

We really encourage independent action. But if you make a purchase that the model doesn't, you must use the same analysis tool (AAII's Stock Investor Pro or another service) you used to qualify the purchase to analyze when to sell it according to the portfolio rules.

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It seems that many of the stocks qualify because they are in a price downtrend. Isn't that contrary to momentum theory?

Yes, our approach is partly a contrarian approach. Prices go down for various reasons and we try to avoid companies in a death spiral by requiring positive earnings, which usually gives the company time to turn around. Many price downtrends are due to the stock or industry being out of favor or due to a temporary problem. In these cases, which are by far the majority, we anticipate a turnaround and it is often dramatic.

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The rules suggest investing in at least 10 stocks, but how do I choose the 10 stocks?

Since the Shadow Stock Portfolio is not an advisory service, it assumes that you are doing further analysis on your own before investing. You can use the list of Passing Companies as a starting point— these are all the stocks that meet the purchase rules of the Shadow Stock Portfolio using current data (the list is updated once a month). As you investigate the stocks, you may come across reasons to eliminate some, and you can devise your own methods for winnowing the list. If you are looking at stocks in the Actual Portfolio, you will want to avoid any that are approaching a value or size limit or are on earnings probation (shown in the Notes column), as these may be dropped from the portfolio at the next quarterly review. If you are selecting among qualifying stocks, ranking the selections by price-to-book-value ratio or bid-asked spread are good approaches.

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If there are more than enough stocks on the qualifying list should I choose by trying to diversify by industry?

We feel it is better to choose by lower price-to-book-value ratio if the difference is meaningful (0.10 or more, i.e., 0.60 vs. 0.49). If they are close, it is better to choose based on liquidity and narrowness of bid-ask spread. Industry diversification is only partially effective, but if there are virtual ties across all the stated purchase criteria you can use any criteria you like and industry diversification is fine.

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If I invested only $10,000 per stock that would amount to a substantial portion (1% to 35%) of the stock's average trading volume. It seems to me that this may have a substantial effect on the market for a stock when I went to buy and, more importantly, to sell. Do you have any suggestions?

It does require some effort and patience to establish sizeable positions. In the Actual Portfolio, we usually take a month to place all the orders and try to sell on up days and buy on down days. Often we buy a position in segments. The extra (deep discount) commissions are less than the spread savings.

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Often it is difficult to get executions at the recommended spreads. What do I do?

Be a little patient. Buy on down days and sell on up days. We violate our own recommendations sometimes and the results we show are in spite of bidding a little higher. Also, don't measure spreads based on the fake ones when the market is closed.

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Is there a brokerage firm that AAII would recommend for the Shadow Stock Portfolio?

We do not recommend any particular broker, but you may want to use a discount broker to minimize commissions. AAII publishes a Discount Broker Guide each year that lists the services of the most popular firms to help you compare them. Go to this link for the most current Discount Broker Guide.

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If a stock starts to move up as I buy it, how high can I let it go?

Sometimes it is OK to chase a stock a bit, but a price-to-book-value ratio of 1.00 should be the maximum.

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Does AAII or some other company track the Shadow Stock Portfolio as a mutual fund?

No. The Shadow Stock Portfolio is meant to provide a framework for investors who are interested in investing in small-cap value stocks.

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Portfolio Management Issues

I bought two stocks based on the Shadow Stock recommendations. Now, I cannot find them either in the Actual Portfolio or in the Transaction History. Why is this?

The Shadow Stock Portfolio is a real portfolio that we change only quarterly and we follow up only on the stocks in the actual portfolio. There are two ways you can wind up with stocks not in the Actual Portfolio. Every month online we show a list of Passing Companies—stocks that would qualify if we were buying at that time—but these stocks may cease to qualify before our quarterly portfolio review. This usually happens because a stock has gone up too much in price to meet the price-book ratio requirement, but occasionally it happens when a negative earnings quarter is announced before our buying period. The second way you would end up with a stock not in the Actual Portfolio is when there are more stocks that qualify as buys than we have funds for. We think it is good that individuals buy stocks when they qualify and when members have available funds. But it is up to each individual to monitor such stocks themselves to see when they should be sold under the portfolio rules. This can be done quite easily with AAII's Stock Investor Pro software program or at a website such as at Yahoo! Finance where price-book ratios and quarterly earnings are provided.

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Four of my holdings have lost money since I purchased them. Your sell rules do not cover sale of stock at some level of loss to protect overall portfolio returns. Do you have guidance?

Unless we have indicated a sell, we feel that all of the stocks in the Actual Portfolio are still worth holding. Stocks are not sold on price movement alone, although price changes can be a warning to look for something else. A drop in price can mean either the fundamental performance is weak and may get weaker, or that the stock has had temporary problems or is out of favor and is now on sale. In the case of Shadow Stocks, it has been the latter more often than the former. We stick with stocks until they violate our criteria.

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Should I rebalance my holdings?

The only rebalancing we do is when we buy new stocks or buy a bit more of underweighted stocks if they still qualify and we have extra cash. Generally our sell rules will take care of rebalancing. When you add new stocks, buy a quantity equal to the average of your holdings.

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Should dividends be reinvested when using the Shadow Stock Portfolio?

You can take out or reinvest dividends based on your needs. We assume reinvestment in the calculation of returns, and we reinvest in the Actual Portfolio.

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How do you handle proposed buyouts in the Shadow Stock Portfolio?

Since the model portfolio only acts quarterly, nothing is done in many cases because the buyout is complete by the time the review period arrives. If the board has approved a buyout and it seems firm, we look at the discount. If holding the stock until the buyout is complete will yield over 1% a month, we hold; otherwise, we sell. This is mitigated if there are number of stocks that we want to buy but do not have funds to purchase. In this case, we would sell unless the stock was yielding 1.5% a month.

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If a company I hold is bought out by another company for stock should I hold that stock?

Not unless it qualifies as a buy, which would be unusual. However, if you are close to a long-term gain, there probably is no reason to rush.

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What should I do if a stock I hold is delisted?

If a company is delisted we would hold it until it violates a sell rule, even if it is a bulletin board or pink sheet stock. However, we would sell if the company indicated that it looked like their finances were such that it would be in violation of portfolio rules even before the official filing. This would occur if they indicated a past year and following quarter were going to show negative earnings. In the model portfolio we would only act quarterly, but individuals are free to make changes anytime.

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