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AAII Model Portfolios Small Cap Value Investing

The Impact of Winter’s Volatility on the Shadow Stock’s Rules

Volatile market conditions in December and January caused fluctuations in the market-cap breakpoint used to identify Shadow Stocks, but not enough to warrant altering it. Plus, two stocks were sold from the portfolio.

by John Bajkowski | April 2019

Volatile market conditions in December and January caused fluctuations in the market-cap breakpoint used to identify Shadow Stocks, but not enough to warrant altering it. Plus, two stocks were sold from the portfolio.

 

The stock market bounced back strongly to start 2019, giving investors the best two-month start to a year since 1991. Small-company stocks have been especially strong performers this year, with the Vanguard Small-Cap Index fund (NAESX) up 17.2% versus the 11.5% gain for the large-cap Vanguard 500 Index fund (VFINX). The Model Shadow Stock Portfolio was up 20.3% year to date through the end of February (Figure 1).

Generally, the fortunes of large-company stocks are tied more to global economic events, while small-company stocks tend to be more domestically focused. The companies that make up the S&P 500 index obtain around 40% of their revenue outside the U.S. Smaller companies also tend to be slightly weaker financially than larger companies, often exhibiting slimmer profit margins. These characteristics make them more sensitive to interest rates and economic cycles. While there are concerns over a weakening domestic economy, it still looks healthier than that of many other nations. As investor sentiment improved from very pessimistic levels at the end of 2018, shares of small-company stocks bounced back strongly.

 

The performance of growth- versus value-oriented stocks was mixed during the first two months of the year. Large-cap growth stocks were up 11.9% versus the 11.0% gain for large-cap value stocks, but the pattern is reversed in the mid- and small-cap segments, with mid-cap growth stocks up 14.3% compared to a gain of 16.1% for mid-cap value stocks. Small-cap value stocks were up 17.0%, while small-cap growth stocks were up 14.0% for the first two months of the year. Market capitalization is simply the number of shares a company has issued multiplied by the share price. It is a common measure of company size and represents the market consensus of a company’s worth.

Stocks in the energy (+14.0%), industrial (+18.6%) and financial (+14.6%) sectors bounced back strongly in 2019, while more defensive sectors such as consumer staples (+7.6%), health care (+6.1%) and utilities (+7.7%) are lagging the market.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 14.8% versus the Vanguard 500 Index fund’s gain of 9.3% per year on average over the same period. Over the same period, the Vanguard Small-Cap Index fund posted an average annual gain of 10.0%.

AAII.com Refresh

We are listening to our members and are in the process of updating our website to add requested features and make it easier to navigate. One notable change is renaming the Model Portfolios section to Shadow Stocks. The Model Shadow Stock Portfolio can now be accessed directly from the site’s main menu as well as from the Premium Services drop-down menu. Shadow Stocks is a core AAII member benefit that helps to illustrate how individuals can translate academic research into an investable portfolio.

The Shadow Stocks area on the website will continue to present the current Model Shadow Stock Portfolio (Actual Portfolio), a listing of stocks currently meeting the strategy’s buy criteria (Passing Companies List), along with guidance on how to follow the strategy (User’s Guide and FAQs), as shown in Figure 2. The area will undergo a visual refresh over the next few months that should make it easier to keep abreast of the portfolio activity and news.

Quarterly Portfolio Activity

Whenever we begin our quarterly review, the size and valuation criteria are studied to determine if any adjustment is warranted. With the large market swings over the last several months, we were curious to see how these factors might have changed.


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-value (P/B) ratio. These decile breakpoints are determined by examining domestic companies that are listed on the New York Stock Exchange (NYSE) and change over time.

Table 1 provides a history of the size and value maximums used to manage the Model Shadow Stock Portfolio. The initial $55 million market-cap maximum for inclusion in the Model Shadow Stock Portfolio has grown to $400 million. The price-to-book-value ratio has fluctuated as well. It was lowest during 2001 and 2002, at 0.60, and is currently at its highest level of 1.00.

At the end of 2018, the NYSE market-cap cutoff for the lowest decile had dropped to $276 million from $387 million at the end of 2017. It stood at $330 million at the end of February. The price-to-book-value cutoff for the lowest decile had dropped to 0.72 at the end of 2018 from 1.00 at the end of 2017. It has since bounced back to 0.86 at the end of February. With the market rebound, we did not adjust the valuation or size cutoffs for the Model Shadow Stock Portfolio for our quarterly review.

Portfolio Changes

Table 2 lists the stocks currently in the Model Shadow Stock Portfolio and Table 3 summarizes the changes made during the quarterly portfolio review.

Two stocks were sold from the portfolio after conducting the quarterly review—Aceto Corp. (ACET) and Seneca Foods Corp.(SENEA). The proceeds from these two sales, as well as the cash held in the portfolio, were not enough to invest an average position size amount in even one replacement stock.

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 capitalization 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 billion.

Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above three times the initial criterion and there is a stock to replace it. The current initial price-to-book ceiling is 1.00. Stocks are marked “approaching value limit” if their current price-to-book-value ratio exceeds 2½ times the initial criterion, or 2.50.

Earnings Probation: If 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 sell them. Otherwise, earnings from continuing operations are used. The date is the fiscal quarter during which the company first reported negative trailing 12-month earnings.

Qualifies 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.

See the Shadow Stocks area of AAII.com for more information.

It is the policy of the Model Shadow Stock Portfolio not to underweight or overweight new positions. Instead, we typically hold excess cash until there is enough to buy a new stock with a position size roughly equivalent to the average position size in the portfolio.

However, if you are looking for stock ideas to invest excess funds, the list of Shadow Stocks that currently qualify represent a good starting point. As of the end of February, 20 stocks met the initial selection criteria for the Model Shadow Stock Portfolio. The list of passing companies is published in the Shadow Stocks section of the AAII website in a table labeled as Passing Companies List. Five of the 20 passing companies are currently held in the Model Shadow Stock Portfolio—Beazer Homes USA Inc. (BZH), CPI Aerostructures Inc. (CVU), Flexsteel Industries Inc. (FLXS), Hallador Energy Co. (HNRG) and Universal Stainless & Alloy Products (USAP). They are designated as “qualifies as of 2/28/2019” in the notes column of Table 2. Note that on our website, the “currently qualifies” label for the actual Model Shadow Stock Portfolio table is revised daily and dynamically updated.

 

 

 

 

Aceto Corp. (ACET)

Aceto filed for Chapter 11 bankruptcy protection from its creditors, leaving its equity stock worthless. The company indicated that it intended to sell its operating units under the supervision of the bankruptcy courts in New York and New Jersey. So far, Aceto has announced plans to sell its pharmaceutical ingredients and performance chemicals segments and the nutritionals portion of Aceto’s human health segment for $338,000. The sale is intended to constitute a “stalking horse” bid that is subject to higher and better bids by third parties in accordance with bidding procedures to be approved by the bankruptcy court.

This is the second time in 26 years we have had a bankruptcy in the portfolio, since companies generally get sold because of negative earnings long before they go bankrupt. Jackson Hewitt Tax Service was held in the Model Shadow Stock Portfolio when it filed for bankruptcy in 2011.

Seneca Foods Corp. (SENEA)

Seneca has been on earnings probation since it announced its first-quarter 2019 earnings on August 1, 2018. At that time, the company’s trailing 12-month earnings per share turned negative. On February 1, the company reported a quarterly loss—adjusted to account for discontinued operations—of $2.07 per share. If a Shadow Stock that is on earnings probation reports a subsequent quarterly loss, it is sold from the portfolio.

Stocks Approaching Size & Value Limits

Stocks are sold during our quarterly review if their market capitalization goes above three times the initial maximum criterion of $400 million and there is suitable stock available for purchase. As noted in Table 2, PC Connection Inc. (CNXN) and Renewable Energy Group Inc. (REGI) are approaching the market capitalization cut-off of $1.2 billion. PC Connection had month-end market cap of $1.070 billion, while Renewable Energy Group had month-end market cap of $1.003 billion.

We also look at the price-to-book-value ratio during the quarterly review and sell any companies if the ratio exceeds three times the initial price-to-book-value limit of 1.00. Currently, PCM Inc. (PCMI), with a price-to-book-value ratio of 2.76, is approaching the price-to-book-value ratio limit of 3.00.

Following Shadow Stocks

The next quarterly review of the AAII Model Shadow Stock Portfolio will take place around the end of May 2019, after most of the Shadow Stock holdings have announced their quarterly earnings. Any changes to the portfolio will be announced at the time they are made here and in a special Model Portfolios Update email (sign up at www.aaii.com/email).

Discussion

charlie bird from WASHINGTON posted over 7 years ago:

I'm sorry to say this , but putting one of my ira into AAII shadow stocks has been a disaster.I've been using AAII's stocks for a few years now and it hasn't turned out well. Only good thing I can say is when you said sell alamo group I didn't and that turned out well. I getit that last year was a bad year for shadow stocks but frankly you didn't do all that well in prior years. and 1st quarter of this year has been bad for the shadow in my port. aceto amira, beazer and a host of others. too bad my wife already paid the renewal because it has been truly a waste of money. (I have been a long time member) I can do better than this on my own and I will farewell


Karen from MN posted over 7 years ago:

Charlie, After watching this portfolio for years, I bought in over the course of 2018. I am having a similar experience to you, and reading a lot more broadly than I was. This article article mentions that the small stocks have rebounded nicely in this first quarter of 2019. Not happening for me.


Mary from OH posted over 7 years ago:

I am having a simliar experience with the Shadow Stocks to Charlie and Karen. I'm narrowly in the black at the moment, but so many of the stocks haven't done well since I entered in 2014. I don't see anywhere near the 14 or 15 % total that is reported every review. Granted, I haven't been able to purchase a number of the stocks b/c they were not qualified buys at the time, but most of the gains must be in stocks held before I could enter. How do others deal with this reality?


Bryan from MI posted over 7 years ago:

I'm having similar experience as Charlie, Karen, and Mary. Stocks may have been up the first 2 months of the year but it no where near offsets the declines that happened during Q4 of 2018. Having been tracking the portfolio in an IRA the past few years and the majority of the holdings that have qualified as I bought in have declined by at least 20%. If I could do it over I'd go back and just buy the SPY. Quite frustrating frankly.


brent from AR posted over 7 years ago:

john, how do I cancel my susb to your issue address? since you sold it? they will not let me cancel my subs. thanks


Charles Rotblut from IL posted over 7 years ago:

Hi Brent, You can contact member services either by sending them a message or by calling at (800) 428-2244. -Charles


James F from TX posted over 7 years ago:

In the earnings probation section of this article, it states "When available, adjusted (non-GAAP) earnings are used to put stocks on probation or sell them". How can I find the adjusted earnings in Stock Investor Pro? What is the data category and field definition for adjusted earnings? Thanks.


Mark from SD posted over 7 years ago:

The market is expensive, we are in the late stage of the market cycle. The indexes keep going up because money is going into the the few stocks that make up the bulk of the cap weighted indexes. This part of the cycle is tough on small and mid cap stocks. I know I watch the numbers of New Highs vs New Lows, Advancers vs decliners etc. Look at the equal weight indexes. RSP and IWS are not making new highs. This situation won't change much until the bears have a romp in the woods.


Paul from ID posted over 7 years ago:

Figure 1 of the article says a lot. There have been several times in the past 26 years where the Shadow Stocks have returned 0% gain after several years. If you entered the Shadow Stocks in late 2017 or early 2018 like I did, you may indeed be negative, as am I, and many others who commented here are. But that is the nature of the beast. Unless AAII is lying, the 26 year performance is great. Pick any 1, 2 or 4 year period and you may have results that are less than optimal (far less). But here is another thing that struck me. Are some of the commenters really going to exit this method now? Aren't the greatest gains to be made (on the long side) when everyone else thinks the world is ending and they can't sell fast enough? Isn't that the exact time to buy for maximum profit? Who bought bank stocks in February of 2009? I'm pretty sure the news at the time was that capitalism had failed and banks were going to close their doors, forever. It didn't happen. Anyway, I don't know if the shadows stocks (on average) will go up, down, or sideways for the next 1, 3, or 5 years. History says they should continue up in a zig zag pattern. So if you have 5 or 10 years to hold you money, historically it looks like a good method. I will keep going with this method with a portion of my portfolio.


David from California posted over 7 years ago:

I have been following AAII for a couple of years. Maybe in the long run, since the 90's it is performing. What about the last 2 to 5 years? Seems that all the stocks are not anywhere near their previous highs. How can the stock selections meet the standards if they are all recovering? A stock selection goes bankrupt? Why was it bought in the first place? Why wasn't it sold before going bankrupt? I am trying to understand how AAII is positioned to help me make money.


m j from ny posted over 7 years ago:

add cost basis and DATE of purchase to your report each time....then your readers will bitch less...maybe.


Charles Rotblut from IL posted over 7 years ago:

MJ, A detailed list of transactions can be found here. -Charles


Doug from NY posted over 7 years ago:

Morningstar had an overview of the "Small-Firm Effect" yesterday that might be relevant: https://www.morningstar.com/articles/927504/sizing-up-small-caps.html


Jean from AAII posted over 7 years ago:

Thanks for the Morningstar article link. The author, Ben Johnson, is actually speaking at our Investor Conference this fall: https://www.aaii.com/conference


Tony from Illinois posted over 6 years ago:

Charlie and John, Like some of the others, I'm a long time subscriber who has been very disappointed with the results over the past few years. I think you guys owe it to your subscribers and readers to analyze WHY the recent year results have been so poor and why the model hasn't prevented some large losses. It would seem to me that buying at or near 52 week lows should limit the downside, but that hasn't been the case. I understand that certain indexes are doing well because of the growth stocks, and I don't mind if the Shadow Stock portfolio doesn't grow as fast, but it is troubling that it has had negative returns in an up market. Can you comment?


Tony from Illinois posted over 6 years ago:

Charlie and John, Like some of the others, I'm a long time subscriber who has been very disappointed with the results over the past few years. I think you guys owe it to your subscribers and readers to analyze WHY the recent year results have been so poor and why the model hasn't prevented some large losses. It would seem to me that buying at or near 52 week lows should limit the downside, but that hasn't been the case. I understand that certain indexes are doing well because of the growth stocks, and I don't mind if the Shadow Stock portfolio doesn't grow as fast, but it is troubling that it has had negative returns in an up market. Can you comment?


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