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AAII Model Portfolios
A look at the strongest and weakest months for the Model Shadow Stock Portfolio over its 27-year history.
As Jeffrey Hirsch noted in his AAII Journal article on season patterns, “those who study market history are bound to profit from it.” (“Using Seasonal and Cyclical Stock Market Patterns” June 2013).
It has been observed that small-cap stocks tend to outperform large-cap stocks during January, perhaps helped by year-end tax-loss selling that has a greater impact of temporarily depressing the prices of less-liquid small-company stocks in December.
We have certainly observed a “January Effect” with the Model Shadow Stock Portfolio. The portfolio has an average monthly return of 1.3% over its 27-year history, but during January, the average monthly return has been 2.0%, which is 1.3 percentage points above that of the S&P 500 index.
However, on average, March has been the strongest month for the Model Shadow Stock Portfolio. The portfolio has an average monthly return of 2.5% during March, compared to 1.5% for the S&P 500. Interestingly, February has been a relatively weak month for both the Model Shadow Stock Portfolio and the S&P 500, with a 0.9% and 0.3% average monthly gain respectively. Historically, August has been the weakest month over the last 27 years, with an average monthly return of negative 0.4% for the S&P 500 and a positive 0.2% average monthly return for the Model Shadow Stock Portfolio.
Longer-Term Performance
As the year was coming to a close, the returns of small-cap stocks continued to lag those of larger companies during 2019. The S&P 500 as measured by the Vanguard 500 Index fund 
(VFINX) is up 27.5% for the year through the end of November, well above the 15.7% year-to-date return for the Model Shadow Stock Portfolio. Over its 27-year history, the Model Shadow Stock Portfolio has outperformed the S&P 500 during 16 calendar years, or 59% of the years.
It has been observed that while the returns of small-cap stocks tend to outperform those of large-cap stocks over the long term, they also tend to undergo periods of underperformance.
Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 14.1% versus the Vanguard 500 Index fund’s annual return of 9.6%. Over the same period, the Vanguard Small-Cap Index fund (NAESX) posted an average annual gain of 10.0%. Figure 1 summarizes the long-term performance.
Portfolio Changes
Table 1 shows the current holdings in the Model Shadow Stock Portfolio. The primary Model Shadow Stock Portfolio selection criteria target the intersection of the smallest 10% of domestic stocks as measured by market capitalization and 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).
The analysis of the stocks listed on the NYSE led to an adjustment of the market cap criterion to an initial range of $30 million to $300 million, while the price-to-book ratio initial requirement was adjusted to a maximum value of 0.90. Stocks are removed from the portfolio if they have values that exceed the initial market cap or price-to-book ratio by a factor of three during the quarterly portfolio review.
After conducting this quarter’s review of the Model Shadow Stock Portfolio in early December, two stocks were removed from the portfolio—Renewable Energy Group (REGI) and PC Connection (CNXN). Table 2 summarizes the changes. The detailed Model Shadow Stock Portfolio Rules box at the end of this article note the purchase and sell rules and provide some portfolio management rules as well as buy and sell tips.
Sold: Renewable Energy Group (REGI)
Renewable Energy Group has been on earnings probation since it announced its second-quarter 2019 earnings. On August 6, the company reported an adjusted second-quarter loss of $1.64 per share, which pushed the trailing 12-month earnings negative. On November 5, Renewable Energy Group reported a third-quarter adjusted loss of $0.41 per share while trailing 12-month earnings remained negative. If a Shadow Stock that is on earnings probation reports a subsequent quarterly loss, it is removed from the portfolio.
Sold: PC Connection (CNXN)
At the end of November, PC Connection exceeded the market-cap ceiling of $900 million with a market cap of $1.31 billion. It is the policy of the Model Shadow Stock Portfolio to sell a stock once its market cap reaches three times the initial purchase limit, which is now $300 million.
Quarterly Additions
As of the end of November, 17 stocks met the initial selection criteria for the Model Shadow Stock Portfolio, up from 16 at the end of October. AAII members can see and research which companies are currently passing the initial selection criteria in the Shadow Stock Ideas table on AAII.com.
With the cash on hand and the proceeds from the two sells, there were enough funds to purchase three new stocks with a position size roughly equal to the average position size for the portfolio holdings: Bassett Furniture Industries (BSET), Cumulus Media Inc. (CMLS) and Perion Network Ltd. (PERI).
Purchased: Bassett Furniture Industries (BSET)
Bassett Furniture trades on the Nasdaq Global Market exchange and is a manufacturer, importer and retailer of home furnishings. Its range of furniture products and accessories are sold through a nationwide network of over 90 retail stores known as Bassett Home Furnishings.
Purchased: Cumulus Media Inc. (CMLS)
Cumulus Media is a leading audio-first media and entertainment company delivering content to over a quarter billion people every month. It offers local programming through 428 owned-and-operated stations across 87 markets. Cumulus Media is also a provider of country music and lifestyle content through its Nash brand, which is distributed through radio programming, Nash Country Weekly magazine, video and live events.
Purchased: Perion Network Ltd. (PERI)
Perion Network is an Israel-based global technology company that delivers data-driven online advertising and search solutions to brands and publishers. Its business solutions include Undertone, CodeFuel, MakeMeReach and Smilebox.
Next Portfolio Review
The next quarterly review of the AAII Model Shadow Stock Portfolio will take place at the end of February. In the meantime, you can follow the portfolio in the Shadow Stocks area on AAII.com. To receive monthly email updates along with alerts to any changes made to the portfolio, please sign up at www.aaii.com/email.
Shadow Stock Portfolio Rules
Purchase & 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 or equal to 0.90. (This figure will change gradually with changes in overall market values.)
- Market capitalization must be between $30 million and $300 million. (This 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 and, if there are earnings estimates, the estimates must be positive for the current quarter and year.
- No financial stocks or limited partnerships will be purchased.
- No stocks in the utility sector will be purchased.
- No stocks in the rental and leasing industry will be purchased.
- No stock on foreign exchanges or ADRs will be purchased because of different accounting and/or withholding tax on dividends. Foreign stocks traded on U.S. exchanges are OK with one exception: The stock of any company whose primary business is in China will not be purchased.
- 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. (This figure may change gradually with changes in overall market values.)
- Eliminate any company that failed to file a 10-Q (quarterly) report in the last six months.
- Momentum is used as a tie-breaker among qualifying stocks. A ranking on four-week relative strength is used as a tie-breaker.
Stocks are sold if any of the following occur:
- 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 from continuing operations becoming positive, the stock is sold. When available, adjusted (non-GAAP) earnings are used to put stocks on probation or sell them. These are earnings that have been adjusted to eliminate the impact of non-recurring events such as markdown of inventory or goodwill. These are earnings reported in the media, in press releases and used in estimates of future earnings. Adjusted earnings are used because the information appears much sooner than official filing data. Otherwise, earnings from continuing operations are used.
- 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.
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Stocks that have been held for four years can be sold unless:
- they currently qualify,
- they are up more than 40% from their purchase, or
- there is no qualifying stock to replace them.
- If a stock has been held for over four years, it needs to be up 10% per year held to avoid being sold (for example, a stock held six years needs to be up 60%). Time and return are based on the initial purchase for the portfolio. Sells are made only if there are suitable replacements.
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.
- The average daily dollar volume should be at least 10 times the amount needed for your position. This will ensure liquidity to get in and out of the position, even if you need to grow the position gradually and sell gradually. This will result in a varying number of qualifying stocks for each investor.
- 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 done at the end of 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 are kept in cash until the next quarter. If too much cash is accumulated, the rules will be adjusted.
- At the end of a quarter, if receipts from stock sales are insufficient to buy all newly qualifying stocks, purchases are made based on the width of the bid-ask spread and the number of shares at bid or ask price.
- 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.
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