When we last looked at the Model Shadow Stock Portfolio in July, it was sputtering—seemingly out of gas—along with the rest of the market. In my comments (“Shadow Stock Portfolio Still Leads as Market Runs Out of Gas,” July 2005 AAII Journal), I concluded with the thought that perhaps the summer, which is usually lackluster, will surprise us.

And it certainly did!

Over the last three months, the Model Shadow Stock Portfolio found enough fuel to come roaring back, generating 19.1% over three months.

Year-to-date (through August 31), it is up 17.8%. In comparison, the S&P 500 portfolio (represented by the Vanguard 500 index fund) has a year-to-date return of 1.9%, and the Vanguard Small Cap Index fund is up 5.4% over the same period. [Figure 1 provides returns over various periods for the Model Shadow Stock Portfolio and the comparison indexes.]

I hope your individual portfolios did at least as well.

Portfolio Activity

Table 1 highlights the activity in the portfolio during the last three months, while Table 2 shows the current holdings in the Model Shadow Stock Portfolio.

Both Gehl Company (GEHL) and U.S. Lime & Minerals (USLM) were sold because they went beyond our limits for the stock’s price-to-book-value ratio.

In my view, these stocks still look interesting, and if I managed a growth portfolio I might buy them. However, in managing any portfolio it is extremely important to stick to your chosen strategy; in this portfolio that strategy is to focus on value. And our value stock approach has done so well over time that I must anticipate that new stocks meeting our value criteria will do even better than those that no longer meet that criteria and have turned into growth stocks.

For your own portfolio, if holding these stocks for only a short time longer will mean more favorable capital gains treatment (in other words, any gains will become long term rather than short term), then by all means hold on to them for a while longer.

I would also like to mention that just after we closed portfolio activity for the quarter, Cavco Industries (CVCO) had a price advance that put it slightly above our price-to-book value ratio limit. We will be selling it in November unless its price declines or its book value increases. The three new stocks we purchased over the last three months are also shown in Table 1. We had an excess of funds, so we also added a bit to our holdings in International Shipholding Corp. (ISH) and Pomeroy IT Solutions Inc. (PMRY), which still qualify as buys. The Stephan Co. (TSC) would also still qualify except that they are late in filing their quarterly report and will be delisted if they haven’t filed by September 30. Although they will likely comply, we can’t consider them as currently qualified until we see the new figures.

Among the portfolio holdings, there are two buyouts scheduled:

• Metals USA (MUSA) was discussed in the July article. The buyout has not been completed as yet and the discount the market is showing to the acquisition price of $22 would return about 6.4% for a two- to three-month holding period. Clearly, some arbitragers think the acquisition will fail. However, we continue to hold because we don’t need the proceeds and by the time our next quarterly review occurs the acquisition will either be completed or will have been cancelled.

• On September 1, Haggar Corp. (HGGR) announced it was being bought out for $29 per share by year end. Since this was a day after we closed activity for the quarter we won’t do anything until November. However, for your own portfolio you may choose to sell now since the discount from now to the expected close is less than 1% a month.

What Next

The performance of the portfolio over the last three years, as you can see from Figure 1, has been exceptionally good and is way above the portfolio’s long-term return. And while we all like to think our ideas are wonderful, I know that the portfolio cannot continue to return 40% a year indefinitely, or to outpace the S&P 500 by 30% a year.

How well can it do?

A few years ago, I would have been willing to estimate that the portfolio could beat the S&P 500 by as much as 5% to 6% a year, on average, for the long haul. And by the way, that figure, after 30 years in a retirement fund, would provide a nest egg four times that of a portfolio invested in the S&P 500. I made that assessment because I had great faith in micro-cap and extreme value stocks.

While I continue to have faith in those kinds of stocks, I also recognize that more and more money managers are discovering micro-cap stocks. There are not only more traditional mutual funds in this area, but there are also two exchange-traded funds (ETFs) and more on the way [see this issue’s Guide to Exchange-Traded Funds]. While this should help micro caps initially and possibly for several years, over the long term it could reduce returns on these stocks toward, but not as low as, the general market return.

On the other hand, most of the micro-cap mutual fund portfolios are not value-oriented. They also tend to weight their holdings by market capitalization, which means that they have higher percentages of their portfolios invested in the stocks of the largest micro-cap companies. For this reason, I believe our Shadow Stock Portfolio will continue to outperform the market significantly, but not by 10% to 20% a year.

As always, however, I would caution against having all of one’s eggs in one basket. Make sure you diversify any micro-cap holding with holdings in the other asset categories.

I will be reviewing the portfolio again in the AAII Journal in three months. In the meantime, you can always keep abreast at the Model Portfolios area of AAII.com. The complete rules for the Model Shadow Stock Portfolio were provided in the July AAII Journal and will appear again in the January issue (you can also access them at any time at AAII.com in the Shadow Stock Portfolio area).

James B. Cloonan is founder and chairman of AAII.