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- Performance analysis of model portfolio compared to small stocks in general and the broader market
- Overview of criteria for selection and removal along with rationale for changes
- Key factors for stock inclusion: low price-to-book ratio, small market capitalization and positive earnings
After the quarterly review of the Model Shadow Stock Portfolio, two stocks are being removed and one stock is being added.
The stock market rallied in November, fueled by a clear and uncontested presidential election. The Federal Reserve delivered a 0.25 percentage-point decrease in its benchmark interest rate, signaling at the time that it would continue to lower interest rates but was uncertain of the speed of cuts and would let data drive its decisions. The S&P 500 index gained 5.9%, compared to a 7.4% gain for the Model Shadow Stock Portfolio. The market gain was broad and carried over to smaller companies, with the S&P SmallCap 600 index gaining 10.9%, while the S&P MidCap 400 index yielded 8.8% during November.
Since its inception in 1993 through the end of November 2024, the AAII Model Shadow Stock Portfolio had a compound average annual return of 13.3%, versus the Vanguard 500 Index fund’s 
(VFINX) average annual gain of 10.6% over the same period. The Vanguard Small Cap Index fund (NAESX) posted an average annual gain of 10.2% over the same period. Figure 1 shows performance over other time periods.
For 2024 through the end of November, small-cap stocks were still playing catch-up to their larger-cap cousins. The S&P SmallCap 600 was up 18.1% for the year through November 30, 2024, a solid gain but still lagging the S&P MidCap 400’s 22.7% total return and the S&P 500’s impressive 28.1% return over the same period. As for the Model Shadow Stock Portfolio—it was down 0.3% through the end of November.
In November, large-cap growth stocks edged out value stocks with a 5.9% monthly gain versus value’s 5.8%. For 2024, though, it was a total domination—large-cap growth stocks were up 34.9%, while large-cap value stocks trailed at 20.5%. Mid-cap stocks kept the momentum going, with growth stocks gaining 8.8% in November, barely lagging behind the 8.9% gain for value stocks. Through November 30, mid-cap growth stocks were up 25.5% for 2024, outpacing the 19.7% return for mid-cap value stocks.
Small-cap growth and value stocks had a breakout month. Growth stocks surged 11.2% in November, while value stocks weren’t far behind with a 10.7% gain. For 2024 through November, though, small-cap growth was ahead with a 20.7% return, compared to the 15.4% gain for small-cap value.
Small-cap stocks remained attractively priced relative to large-cap stocks. The median price-to-book-value (P/B) ratio of the companies in the S&P SmallCap 600 was 1.89, well below the 3.77 median ratio for the companies in the S&P 500. The S&P SmallCap 600 normally trades at a discounted multiple relative to the S&P 500. The discount has averaged 0.66 since 1998 and was 0.50 as of the end of November.
Quarterly Portfolio Review and Deletions
The Model Shadow Stock Portfolio was designed to test the strategy of investing in the 1% intersection of the smallest and cheapest publicly traded stocks. Research conducted by Eugene Fama and Kenneth French (Journal of Finance, June 1992) showed that the smaller the market capitalization of a company, the higher its stock returns. In addition, the lower the ratio of market price to book value, the higher the returns. The highest returns came from those stocks that were in the lowest market-cap decile and the lowest price-to-book decile.
The primary Model Shadow Stock Portfolio selection criteria target the intersection of the smallest 10% of domestic stocks as measured by market cap, along with the “cheapest” 10% of domestic stocks as measured by the price-to-book ratio. These decile breakpoints are determined by examining domestic companies that are listed on the New York Stock Exchange (NYSE) and then applying the size and value breakpoints for stocks listed on all domestic exchanges. The intersection of 10% constitutes the primary initial selection universe.
Approaching Size Limit: Stocks are sold if their market capitalization goes above three times the initial maximum criterion and there is a stock to replace it. The current market-cap maximum for initial screening is $400 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $1.0 billion.
Approaching Value Limit: Stocks are sold once their price-to-book-value (P/B) ratio goes above three times the initial criterion and there is a stock to replace it. The current initial price-to-book ceiling is 0.90. Stocks are marked “approaching value limit” if their current price-to-book ratio exceeds 2½ times the initial criterion, or 2.25.
Earnings Probation: If the last 12 months’ earnings 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. When available, adjusted (non-GAAP) earnings are used to put stocks on probation or remove them. Otherwise, earnings from continuing operations are used. The date is the calendar quarter for which the company first reported negative trailing 12-month earnings.
Qualifies As Of: Stock still qualified as an addition when the screen was run with current data. Stocks that don’t currently qualify as an addition are held until they meet one of the deletion rules.
TTM Adjusted Earnings Positive: Trailing four-quarter GAAP earnings are negative, resulting in no meaningful figure for the price-earnings (P/E) ratio. However, adjusted earnings for the period are positive.
Table 1 shows the stocks that currently make up the Model Shadow Stock Portfolio. The model portfolio is reviewed quarterly to determine portfolio deletions and additions. The quarterly review cycle is tied to the reporting cycle of most firms and limits costly portfolio turnover. AAII’s stock analysis and screening service Stock Investor Pro, with data as of December 13, 2024, was used for the fourth-quarter review. After conducting the review, there are two deletions and one addition, as summarized in Table 2.
Value Factor
The price-to-book cutoff has decreased slightly from 0.85 in September to 0.83. At the time of review, the initial qualifying maximum price-to-book ratio was 0.90 and we left it unchanged. Qualifying stocks must have a price-to-book ratio of 0.90 or lower when added to the model portfolio. There were 1,265 exchange-listed securities with a price-to-book ratio less than or equal to 0.90, up from 1,170 in September. Stocks in the model portfolio are removed for valuation if they exceed three times the initial maximum price-to-book ratio at the time of a quarterly portfolio review.
Covenant Logistics Group Inc. (CVLG) had the highest price-to-book ratio in the model portfolio of 1.89. No stocks in the model portfolio exceeded the maximum price-to-book ratio at the time of review.
Size Factor
We examined the market-cap levels of domestic companies listed on the NYSE to determine the size cutoff for the lowest decile when adding stocks to the model portfolio. The lowest decile market-cap level increased from $299 million in September to $380 million using data in Stock Investor Pro as of December 13, 2024. We therefore raised the maximum initial qualifying market-cap value from $300 million to $400 million. There were 1,390 exchange-listed securities with a market cap between $30 million and $400 million. Holdings are removed if their market cap goes above three times the initial criterion at the time of the quarterly review.
Covenant Logistics Group also had the highest market cap of $763.1 million, but this did not exceed the $1.2 billion market-cap maximum at the time of review.
Negative Earnings Rule
If a company has trailing 12-month earnings from continuing operations that are negative, the stock is placed on probation; if a subsequent quarter has negative earnings prior to trailing 12-month earnings becoming positive, the stock is deleted. When available, adjusted (non-GAAP) earnings are used to put stocks on probation or remove them.
Mistras Group Inc. (MG) came into the quarter on earnings probation, while American Vanguard Corp. (AVD) and Hooker Furnishings Corp. (HOFT) went on earnings probation during the third calendar quarter of 2024. Mistras’ trailing 12-month earnings turned positive this past quarter and it came off probation. Clarus Corp. (CLAR) went on earnings probation in the second quarter of 2024 but reported positive earnings per share in the third quarter of 2024, as tracked by S&P Global Market Intelligence. Its trailing 12-month earnings are still in the red, and the company remains on earnings probation.
Portfolio Deletion: SigmaTron International
SigmaTron International Inc. (SGMA) has been on earnings probation since the second calendar quarter of 2024, and it reported negative quarterly earnings during the third quarter. It is the policy of the Model Shadow Stock Portfolio to remove a stock once its trailing 12-month adjusted earnings go negative and the company reports a subsequent quarterly loss while trailing earnings are still negative. SigmaTron International is being removed from the portfolio due to negative earnings. SigmaTron International was added to the Model Shadow Stock Portfolio on March 14, 2022, at a price of $8.81 per share. It was deleted on December 16, 2024, at $2.10 per share, for a price loss of 76.2%.
Holding Period Rule
We also examine the portfolio for stocks that no longer meet the initial qualifications, have been held for at least four years and are down from their initial addition price.
Portfolio Deletion: Key Tronic
Key Tronic Corp. (KTCC) has been held for just over four years and is down from its original addition price. It has negative earnings and no longer meets the initial qualifications. Key Tronic is being removed from the portfolio for negative performance since addition. Key Tronic was added to the Model Shadow Stock Portfolio on September 15, 2020, at a price of $7.98 per share. It was deleted on December 16, 2024, at $4.87 per share, for a price loss of 39.0%.
Quarterly Addition
As of December 13, 25 stocks met the initial selection criteria for the Model Shadow Stock Portfolio. AAII members can see and research which companies are currently passing the initial selection criteria in the Shadow Stock Ideas table on AAII.com. The list of new Shadow Stock Ideas is updated daily—Tuesday through Saturday.
Six qualifying stocks were already in the Model Shadow Stock Portfolio at the time of the review. The remaining 19 stocks were examined to ensure adequate liquidity, timely financial filings, and appropriate industry and foreign considerations. The Shadow Stock Portfolio Rules on AAII.com provide guidance on factors to consider when selecting stocks for your portfolio.
With the proceeds from the deletions, as well as the cash held in the portfolio, the Model Shadow Stock Portfolio was able to take a position in one company at just below the average position size for the existing holdings in the tracking portfolio.
Portfolio Addition: Landsea Homes Corp.
Landsea Homes (LSEA) engages in the design, construction, marketing and sale of single-family detached and attached homes in the U.S. The company develops and builds suburban, single-family detached and attached homes; mid- and high-rise properties; and master-planned communities. The company was incorporated in 2013 and is based in Dallas, Texas.
Landsea Homes has a book value per share of $18.27 as of September 30. If you wish to stay within the 0.90 price-to-book maximum, you should pay no more than $16.44 per share ($18.27 x 0.90). However, if the stock price has moved up after being added to the portfolio, you can still purchase the stock unless the price-to-book ratio goes above 1.00, which equates to a price of $18.27 per share. To calculate the maximum purchase price based on the maximum desired price-to-book ratio, multiply the current book value per share ($18.27 for Landsea Homes) by the maximum price-to-book ratio to be considered for the Model Shadow Stock Portfolio (currently 0.90, or 1.00 for loosened consideration).
Next Portfolio Review
The next quarterly review of the Model Shadow Stock Portfolio will take place in March 2025.
If there are any changes to the model portfolio, they will be announced at that time with a special Model Shadow Stock Portfolio Update email. Sign up for this email at https://www.aaii.com/email so you don’t miss it!
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