Shadow Stock Portfolio: About Even Despite High Volatility

by James B. Cloonan

The performance of the Model Shadow Stock Portfolio in 2009 did not replace that of 2003 as the best year ever, but it came close with a return of 72.3% versus 73.1% for 2003. Unfortunately, even this unusually high return did not recover all that was lost in 2008, as can be seen in Figure 1.

We are still 14% below the pre-2008 level. We have to live with the reality that when you go down by 50%, you have to go up 100% to get back to where you were. Long term, the portfolio still has excellent performance, as can be seen in Table 1. The S&P 500 (represented by the Vanguard 500 Index fund) was up 26.5% for 2009 and is about 22% below its pre-2008 level.

Year-to-date (as of the end of February) the portfolio as well as the general market are about even, as can be seen in Figure 1 and Table 1, but there has been high volatility with a weak January and a strong February. The February strength is continuing into early March.

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As shown in Figure 2, the number of stocks passing our initial screen dropped to 12 this quarter, which is down a bit. After a few more quarters, we will see if we can correlate the number of qualifying stocks with market behavior. Some of the qualifiers were already in the portfolio, and we made the choices here based primarily on lower price-to-book-value ratios.

Let me emphasize again that this is a real portfolio with real assets and not an advisory letter. We can buy stocks only when we sell stocks and free up funds.

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Portfolio Changes

We sold two stocks, Greenbrier Companies (GBX) and L.S. Starrett Company (SCX), because they violated their probation. In addition, Allion Healthcare (ALLI) was bought out by H.I.G. Capital for $6.60 per share.

We added three stocks to the portfolio: CSS Industries (CSS), Lithia Motors, Inc. (LAD), and PC Mall, Inc. (MALL). These actions are summarized in Table 2. The revised portfolio is shown in Table 4.

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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 $200 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $500 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 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.

Earnings, Earnings, Earnings?

There are three different definitions of earnings that are often used without distinguishing them from one another. We have been guilty of this sometimes, and I want to clear up how we use the three definitions. The three are:

GAAP Earnings. These are the earnings as calculated by
generally accepted accounting principles. It is the approach required on all filings with the SEC.

GAAP Earnings from Continuing Operations. The above GAAP earnings are generally adjusted to eliminate some gains or losses that are not ongoing—such as from discontinued activities.

Adjusted Earnings. These are earnings that have been adjusted to eliminate the impact of non-recurring events such as a markdown of inventory or goodwill. These are the earnings reported in the media, in press releases, and used in estimates of future earnings. Whenever they are used by a public company, there will be a footnote showing how GAAP earnings were adjusted. But adjusted earnings is what is generally meant when “earnings” are referred to.

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We use GAAP earnings from continuing operations to screen stocks for inclusion in the portfolio initially. We do this because the figures have been reported to the SEC and are extremely dependable and it is somewhat more conservative.

We use adjusted earnings to put stocks on probation or sell them. We do this because the information appears much sooner than official filing data. In addition, I believe there is little reason to sell a stock based on something that has happened, won’t happen again, and is already in the price. In buying or selling, we use an approach that is most likely to reduce turnover, which is expensive in micro-cap stocks. We should point out that, in the majority of cases, there is no difference between GAAP and adjusted earnings.

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. (Figure will change gradually with changes in overall market values.)
  • Market capitalization must be between $17 million and $200 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.)

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.) The two years should be measured from the last time the stock qualified, not from when you purchased it.

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.
  • Be careful if the average daily number of shares traded is not four times the amount needed for your position. It may be too difficult to get in and out of the position, but you may be able to grow the position gradually and sell gradually.
  • 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.


Right now, bullish and bearish sentiment seems about balanced. A recovery, unless suddenly aborted, seems well underway except for unemployment, which remains painfully high. While I think portfolios should remain at their long-term allocations, I do feel somewhat concerned that so many of the risk factors are under the control of other nations. This has been true for quite a while now, but the financial disturbances in the eurozone make it more apparent at this time.

Many pundits feel 2010 will be an average year for stocks, and the election cycle indicator for the second year after a presidential election would agree with an average performance of 11.5%. However, it’s getting hard to remember what average or normal means.

We will be reporting on the Model Shadow Stock Portfolio again in the July AAII Journal. In the meantime, you can follow the portfolio at

About the Model Shadow Stock Portfolio

The Model Shadow Stock Portfolio provides guidance for investing in the promising micro-cap value sector of the market. It reflects AAII Founder James B. Cloonan’s investing philosophy, which holds that:
  • The best stocks for individual investors are not the same stocks that are best for institutions, and
  • Success comes more from concern for the overall portfolio than for individual stocks.

The Model Shadow Stock Portfolio is an actual portfolio with real dollars invested. Updates on portfolio activity are provided both in the AAII Journal in this column, and on our Web site at