August Model Shadow Stock Portfolio Update

When examining quarterly company results, it is normally best practice to compare a quarter to its counterpart last year. This is in contrast to annual results, which are examined sequentially, one after another. As we prepare for our upcoming Model Shadow Stock Portfolio quarterly review, we are examining the sales and earnings from the second quarter and comparing them to the second-quarter results in the previous year. Normally looking at year-over-year quarterly results as opposed to a sequential quarterly comparison helps to account for the typical seasonal swings that occur over the course of the year. A year-over-year comparison should help reveal the direction and strength of the company’s growth and the effectiveness of management.

Of course, the last year and a half have been nothing near normal. The impact of the coronavirus pandemic was strongly felt in the second quarter of 2020. This year, as companies report second-quarter results, we are seeing extremely strong year-over-year comparisons. For the most recent quarter, the average year-over-year revenue growth is 37.5%, while the average year-over-year earnings per share increase is 99.2% for the stocks currently in the Model Shadow Stock Portfolio. The median (or midpoint) value that helps to alleviate the impact of extreme numbers observed with averages is very similar. The median year-over-year quarterly revenue growth is 25.5%, while the median earnings per share growth is still 99.2%.

For the same stocks currently in the Model Shadow Stock Portfolio, last year for the second quarter they were reporting a drop in revenue of 15.1% on average (11.7% median) year-over-year and a decrease in earnings per share of 42.6% on average (26.2% median) compared to the second quarter of 2019.

Similar results can be observed by most stocks. For example, the stocks in the S&P 500 index have averaged a 37.9% year-over-year gain in revenue for the most recently reported quarter this year compared to a decline of 10.2% year-over-year last year. As you may have noted, changes in earnings per share have been even more dramatic. With companies in the S&P 500 reporting an earnings gain of 107.8% average (62.7% median) year-over-year for the most recent quarter compared to a decline of 46.5% average (19.9% median) last year.

The coronavirus pandemic created a sudden and extreme decline in economic activity last year. As companies reported poor results, a number of Model Shadow Stock Portfolio holdings were placed on earnings probation. Other shadow stocks were suddenly showing losses under generally accepted accounting principles (GAAP) but also supplied adjusted earnings that were positive because nonrecurring events were excluded from the calculation. We are now seeing the Model Shadow Stock Portfolio holdings coming off earnings probation and notes are being removed regarding the disparity between adjusted earnings and GAAP earnings.

There are many factors influencing the economy and the market beyond the coronavirus, yet the virus continues to strongly influence economic behavior globally and, in turn, the stock market. The highly contagious delta variant is throwing a monkey wrench into the post-pandemic reopening plans of many institutions. Counties that were able to contain the spread of coronavirus with strict social distancing and quarantine mandates now find themselves dealing with strong outbreaks. It serves as a reminder that it is the unexpected events and news that make major impacts on the market, as millions of market participants suddenly change their opinion of likely future outcomes. As former U.S. Defense Secretary Donald Rumsfeld famously noted, it is the unknown unknowns that drive the biggest surprises when they are revealed. The unknown unknowns are the things that we are neither aware of nor understand yet will come to impact us: “There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know.”

Monthly Observations

Twenty stocks met the initial selection criteria for the Model Shadow Stock Portfolio as of August 11, 2021, unchanged from the number of passing stocks one month ago. 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 Shadow Stock Ideas is updated daily, Tuesday through Saturday.

Of the 20 qualifying companies, six were held in the Model Shadow Stock tracking portfolio at the time: Hurco Companies Inc. (HURC), Key Tronic Corp. (KTCC), Mesa Air Group (MESA), New Home Company Inc. (NWHM), Orion Group Holdings Inc. (ORN) and Strattec Security Corp. (STRT). Pangaea Logistics Solutions Ltd. (PANL) came off the qualifying list over the course of the month for a technical reason. The company reported earnings on August 10, 2021, and our data vendor Refinitiv is awaiting formal SEC filings to provide detailed earnings per share information.

Ironically, one addition to the list of qualifying stocks over the course of the last month is also one that needed to be sold because it is being acquired by a private equity fund affiliated with Apollo Global Management Inc. The company started to meet the initial selection criteria again this month after reporting positive earnings for the quarter ending June 30, 2020, therefore removing the large nonrecurring loss from the quarter ending June 30, 2021, from its trailing 12-month earnings per share calculation.

New Home Company announced that it had entered into a definitive merger agreement to be acquired by Apollo Funds for $9.00 per share in cash. The purchase price represents an 85% premium to the closing stock price on July 22, 2021, of $4.86 per share and a 51% premium to the 90-day volume-weighted average price. The acquisition represents a strong immediate gain for holders of New Home Company, but at $9.00 per share Apollo Funds is able to acquire it with a book value of $11.22.

As of August 11, 2021, Hibbett Inc. (HIBB) had the highest price-to-book ratio in the Model Shadow Stock Portfolio. Its price-to-book ratio of 3.27 is now just below the threshold for removing a stock, Shadow stocks with a price-to-book ratio three times the initial maximum (1.10 × 3 = 3.30) at the time of a quarterly review are removed from the portfolio, assuming there is a suitable replacement.

Hibbett also has the highest market capitalization value of $1,399.8 million as of August 11, 2021. The Model Shadow Stock Portfolio looks for stocks with a market cap (share price times shares outstanding) greater than $30 million but less than $500 million when adding stocks to the portfolio. Shadow stocks with a market cap three times the initial market cap maximum ($500 million × 3 = $1,500 million) at the time of a quarterly review are sold from the portfolio, assuming there is a suitable replacement.

The initial market cap and price-to-book levels are adjusted over time to reflect the changing market conditions. Any changes to the portfolio will be announced at the time they are made in a special Model Shadow Stock Portfolio Update email (sign up at www.aaii.com/email).

Monthly Performance

The small-cap value style continued to underperform the large-cap growth style for the second month in a row. The Model Shadow Stock Portfolio lost 4.0% during July, lowering its year-to-date return to 41.0%. The S&P 500, as measured by the Vanguard S&P 500 Index fund (VFINX), was up 2.4% during July and is now up 17.9% for the year. The Vanguard Small-Cap Index fund (NAESX) gave up 1.4% during the month and is posting a 14.6% gain during 2021, while the DFA U.S. Micro-Cap fund (DFSCX) lost 2.3% during July and is up 23.9% for the year.

Worries over the impact of the delta variant of the coronavirus can be seen in the shift of the best- and worst-performing sectors during July. Defensive sectors performed the best, while cyclical sectors the worst.

Health care was the best-performing sector during July, gaining 4.9%, followed by real estate with a 4.6% gain and utilities with a 4.3% monthly gain. Energy was the weakest sector, losing 8.3% during July, followed by financials (down 0.4%) and consumer discretionary (up 0.5%). The energy sector is still the strongest-performing sector during 2021 with a 33.6% gain during the first seven months of the year. Real estate is now the second-strongest sector for the year with a 29.0% gain, and financials slipped to third place with a gain of 25.0% year to date. Utilities remain the weakest sector for the year, up 6.8% year to date, followed by consumer staples (up 7.7%) and consumer discretionary (up 10.8%).

In the large-cap segment, growth stocks were up 3.8% during July, giving them an 18.6% gain year to date for 2021. Large-cap value stocks were up 0.8% during July and are up 17.2% year to date.

In the mid-cap segment, growth stocks are up 13.4% for the year, after gaining 1.0% during July. Mid-cap value stocks are up 22.7% for the year, after declining 0.2% during the month.

Small-cap growth stocks are up 5.0% for the year, while small-cap value stocks are up 22.2%. Both small-cap styles were down during July. Small-cap growth stocks declined by 3.6% during July, while small-cap value stocks also lost 3.6% during the month.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 15.3% versus the Vanguard 500 Index fund’s gain of 10.4% per year on average over the same period. Over the same period, the Vanguard Small-Cap Index fund posted an average annual gain of 10.7%.

Sell Alert

New Home Company Inc. (NWHM)

The Model Shadow Stock Portfolio is reviewed quarterly to determine stock sales and additions. The quarterly portfolio review cycle is tied to the standard reporting cycle of most publicly traded firms in the U.S. The next quarterly review is scheduled to take place after the end of this month. Occasionally, a special situation arises that requires more immediate action. The acquisition announcement of New Home Company and the need to act on the tender offer is the reason for the sell alert.

New Home Company announced on July 23, 2021, that it had entered into a definitive merger agreement to be acquired by funds managed by affiliates of Apollo Global Management Inc. Under the terms of the agreement, Apollo Funds will commence a tender offer to acquire all outstanding shares of New Home Company for $9.00 per share in cash. The acquisition will transform the company into a privately held enterprise.

The current market price largely reflects the acquisition price of $9.00 per share, so the model portfolio position in New Home Company was sold on August 16, 2021, and the portfolio will hold the proceeds in cash until the full quarterly review is conducted near the beginning of September. The tender offer is currently scheduled to expire at the end of September 7, 2021. If you decide to tender your shares, you must notify your broker ahead of the scheduled expiration.

Next Portfolio Review

The next quarterly review of the Model Shadow Stock Portfolio will take place following the end of August 2021. Any changes to the portfolio will be announced at the time they are made in our Model Shadow Stock Portfolio Update emails (sign up at www.aaii.com/email).

Model Shadow Stock Portfolio News

New Home Company Inc. (NWHM) was the best-performing company in the portfolio for July, increasing 51.6% over the month. The company’s agreement to be acquired by Apollo Funds and become a private enterprise pushed up the stock price to reflect the $9.00 per share cash offer. The acquisition also triggered a sell alert for the company. It is the portfolio’s policy to sell a holding once the board of directors agrees to a merger and the share price substantially reflects the value of the acquisition. The proceeds of the sale will be held until the quarterly review, which is scheduled to take place after the end of August 2021.

SIFCO Industries Inc. (SIF) was the second-best-performing company in the portfolio for July, increasing 10.2% over the month. There was no specific news for the company during July. The company scheduled the release of its second-quarter 2021 earnings for August.

Penn Virginia Corp. (PVAC) was the worst-performing stock in the portfolio for July, decreasing 21.7% over the month. During the month, an announcement was made that the company was under investigation regarding a potential merger. While this is normal, it is something to be aware of if you are a Penn Virginia shareholder. The company also announced a new offering of debt in the form of $400 million in unsecured debt. Read more about the offering below.

Container Store Group Inc. (TCS) was the second-worst-performing stock in the portfolio for July, decreasing 19.3% over the month. There was no company-specific news tied to Container Store’s performance; it was among other stocks in the portfolio with slower business related to the progress of the coronavirus pandemic.

Here are some news highlights from July for the holdings in the Model Shadow Stock Portfolio:

Bassett Furniture Industries Inc. (BSET) reported second-quarter 2021 earnings per share of $0.60, which beat the I/B/E/S consensus estimate of $0.35 per share by 71.4%. Revenue was $124.1 million, beating estimates by $7.9 million and increased by 94.5% over the same period.

CEO Robert H. Spilman Jr. provided insight into the company’s results.

“Consolidated revenue of $124.1 million for our second quarter represented a 94% increase as compared to the pandemic-impacted quarter in 2020 and 15% as compared to 2019. Similarly, strong wholesale orders of $96.0 million for the period increased by 172% versus 2020 and by 51% compared to the pre-pandemic 2019 second quarter. As we battle an extremely tight labor market and continued supply chain disruptions, we strive to chip away at our huge order backlog that grew by another $19 million over the three months. Adding to the complexity is the inflationary raw material spiral that we have confronted this year, leading to our unprecedented action of levying three general price increases since our fiscal year began in December. Amidst this unsettled environment, we were pleased to record an $8.4 million operating profit compared to last year’s loss. EPS advanced to $0.60 per share for the quarter against the COVID-19 affected loss of $2.04 in 2020.”

Bassett Furniture also announced a $0.14 per share quarterly dividend. This represents a 12% increase from the prior dividend and is payable on August 27 to shareholders of record as of August 13.

In addition to the dividend, the board of directors also authorized a $16 million share repurchase initiative.

Beazer Homes USA Inc. (BZH) reported third-quarter 2021 earnings per share of $1.22, which beat the I/B/E/S consensus estimate of $0.90 per share by 35.6% or $0.32. Revenue was $570.9 million, missing estimates by almost $38 million and increased by 7.1% year over year. Adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) increased by 45.9% to $78.8 million.

“We had a very successful third quarter, driven by strong operational execution and continued strength in the housing market,” said CEO Allan Merrill. “We generated significant gains in operating margin and adjusted EBITDA, leading to quarterly net income that was more than double the same period last year. At the same time, we grew our total active lot position while continuing to reduce leverage.”

“We are positioned to generate double-digit growth in earnings per share for shareholders while expanding our ESG activities to create durable value for all of our stakeholders,” said Merrill in regard to fiscal-year 2022.

Covenant Logistics Group (CVLG) reported second-quarter 2021 earnings per share of $0.96, which beat the I/B/E/S consensus estimate of $0.68 per share by 41.2%, or $0.28 per share. Revenue was $256.32 million, beating estimates by almost $32 million and increasing 33.7% year over year.

“We were pleased to report second-quarter earnings of $0.91 per share and adjusted earnings of $0.96 per share, which are the highest earnings for any quarter in the company’s history,” said CEO David Parker. “Although we are pleased with these results, we recognize the opportunity for further improvement, particularly in our dedicated segment. In the short run, this means continuing to improve rates and contractual terms with customers who are not yielding the level of consistent profit we expect from this segment of the business, and in the long run, this means holding ourselves accountable for improved margins and returns across all aspects of our business.”

Delta Apparel Inc. (DLA) announced preliminary results for the third quarter of 2021. The company anticipates net sales to be about $118 million, reflecting a 65% growth rate compared to 2020 but relatively flat compared to 2019. Diluted earnings per share are forecasted to be over $0.90 per share, reflecting a 50% increase over the 2019 fiscal third quarter.

CEO Robert Humphreys commented, “Our June quarter performance is a true testament to the power of our diversified business model. The strong emotional connection to our Salt Life lifestyle brand drove robust consumer engagement that far exceeded our expectations and further validated our belief in this aspirational brand. As we announced last week, we are opening two new retail doors: one in Myrtle Beach, South Carolina, and one in Galveston, our first store in the state of Texas. With 12 Salt Life stores already opened, we have proven the success of this omni-channel shopping experience for consumers. We now plan to accelerate our investments in this key sales channel and look to further expand the Salt Life brand reach with at least five additional retail locations in 2022.”

This follows the announcement that the company will be expanding its operations to new locations, opening stores in Myrtle Beach, South Carolina and Galveston, Texas. The stores are expected to open in late 2021, setting the foundation for increased expansion in 2022.

Ducommun Incorporated (DCO) was granted a contract through 2026 to supply a titanium work package for products on the A320 and A330 programs. The company is a global player in the aerospace and defense industry and a partner of Airbus Detail Parts Partner (D2P).

“We are thrilled and honored to be awarded for the first time a D2P Partner designation by Airbus representing preferred supplier status along with a long-term five-year contract,” said CEO Stephen Oswald. “This is a significant step forward for Ducommun and its industry-leading titanium structural component business and a major milestone in the 172-year history of our company.”

Key Tronic Corp. (KTCC) reported third-quarter 2021 earnings per share of $0.08. I/B/E/S consensus estimates were unavailable. Revenue was $134.6 million, reflecting a 21% year-over-year increase.

Demand was well over $150 million, the highest it has ever been in company history.

“We’re pleased with the successful launch of new programs, and our rebounding and increasing customer demand in fiscal 2021,” said CEO Craig Gates. “We are currently ramping a number of new programs and, while production has been hindered by limited supply of key components, we are extremely encouraged by both new customer and new program wins.”

Gates also spoke about the company’s outlook in 2022, “Moving into fiscal 2022, the COVID-19 crisis, component shortages and logistic delays continue to present macroeconomic along with multiple business challenges, but we continue to see the favorable trend of contract manufacturing returning to North America. We are excited to expand our Mexico operations with new program awards, and also to see our domestic sites benefiting from customers’ onshoring initiatives. We expect continued strong revenue growth in the coming quarters and continue to invest in new capacity to prepare for long-term growth.”

New Home Company Inc. (NWHM) agreed to be acquired by Apollo Global Management Inc. (APO) in an all-cash transaction of $9.00 per share. New Home Company will become a privately run company after the acquisition. The cash offer price reflects an 85% premium over New Home Company’s closing share price on July 22, 2021. The company’s agreement to be acquired pushed up the stock price to reflect the $9.00 per share cash offer. The acquisition also triggered a sell alert for the company. It is the portfolio’s policy to sell a holding once the board of directors agrees to a merger and the share price substantially reflects the value of the acquisition. The proceeds of the sale will be held until the quarterly review, which is scheduled to take place after the end of August 2021.

The company also reported second-quarter 2021 earnings per share of $0.26. No I/B/E/S consensus estimates were available. Revenue was $135.9 million, increasing 75% year over year. New orders increased by 14% year over year, while gross margin was 17.3%

“The momentum we’ve been building since the second half of 2020 continued into the 2021 second quarter from a net order, price appreciation and margin growth perspective,” said CEO Leonard Miller. “For the six months ended June 30, 2021, our adjusted homebuilding gross margin increased 220 basis points to 21.4% as compared to the first half of 2020. We continue to experience challenges related to cost increases, particularly in our Arizona and Colorado markets, but successfully raised prices to cover the majority of these costs during the quarter. Our quarter-end backlog of 632 homes with a value of $439.4 million positions us for a solid second half of 2021.”

Orion Group Holdings Inc. (ORN) reported second-quarter 2021 earnings per share of $0.05, which increased year over year from the $0.04 per share in the second quarter of 2020. Earnings per share fell short of the I/B/E/S consensus estimate of $0.083 per share by 39.7%. Net sales of $145.9 million decreased 20.6% compared to the same quarter in 2020.

Gross income of $12.3 million was a 40.6% decrease over the same year-ago period. Net income for the period was $3.5 million, a 75% increase over the same period of 2020. The company currently has $394.4 million in backlog orders, compared to $528.4 million in the same period of 2020.

“We remain optimistic about our end markets and future project opportunities … We are confident that bidding opportunities will continue to materialize, especially in end markets that have been adversely impacted by COVID … We also are continuing to track progress on the federal infrastructure bill … We are confident in our ability to continue to generate growth in our profitability and maximizing shareholder value over the long term,” said CEO Mark Stauffer.

Guidance for the rest of 2021 was not given, but current I/B/E/S estimates are for fiscal-2021 earnings per share of $0.25.

Penn Virginia Corp. (PVAC) announced the pricing of a $400 million offering of unsecured notes. The notes due in 2026 will have a 9.25% yield and will be sold at 99.018% of par value. The offer was expected to close on August 10, 2021.

Ultralife Corp. (ULBI) reported second-quarter 2021 earnings per share of $0.05, down year over year from earnings of $0.13 per share in the same period of 2020. Earnings missed the I/B/E/S consensus estimate of $0.09 per share by 44.4%. Net sales totaled $26.8 million, a 6.3% decline.

Operations income for the quarter was $1.1 million, a 52.2% decrease over $2.3 million reported in the second quarter of 2020. Gross profit was $7.3 million, compared to $8 million in the same 2020 quarter. Net income also decreased 52.9% year over year, from $1.7 million to $0.8 million.

“Supply chains and logistics continue to be the source of operational challenges, delaying some shipments and increasing freight costs, and clouding our visibility for the second half of the year,” said CEO Michael Popielec. “Nevertheless, activity in our end markets remains high and our goal is to continue improving our financial performance each quarter. We remain focused on executing near-term growth initiatives and developing long-term growth opportunities while adhering to our proven and profitable business model.”

While the company did not give any guidance the full fiscal year of 2021, I/B/E/S estimates are currently projecting earnings per share of $0.34.

VSE Corp. (VSEC) reported second-quarter 2021 adjusted earnings per share of $0.60, the same amount reported in the second quarter of 2020. Earnings beat the I/B/E/S consensus estimate of $0.549 per adjusted share by 9.3%. Net sales for the quarter totaled $175.1 million, a 3.8% increase over the same period of 2020, which saw net sales of $168.7 million.

The company reported a net loss of $12.4 million, a 45.1% increase over the same period of 2020. Gross income for the quarter was down significantly to a loss of $7.1 million, a 139% decrease over the second quarter of 2020. The company is still recovering from the pandemic, which had major impacts on the aviation & aerospace industry. Some expenses and losses were seen as nonrecurring, thus the adjusted earnings per share were positive even though the company operated at a net loss for the quarter.

“We anticipate a continued recovery in aviation segment performance in the coming year, supported by recent contract wins, product and service line expansions, inorganic growth and improved operating efficiencies,” said CEO John Cuomo. “Aviation distribution revenue exceeded pre-pandemic levels during the second quarter, while repair activity continues to improve.”

Guidance for the rest of fiscal-year 2021 was not given, but I/B/E/S analysts estimate the company to have full-year adjusted earnings per share of $2.817.