Barring an epic run during the second half of December, the market is poised to finish in the red for all of 2022. The Model Shadow Stock Portfolio has historically been more volatile than the market with deeper and more sudden downward dips normally followed by more pronounced upward moves.

The Model Shadow Stock Portfolio is down 12.8% for the year through the end of November. The S&P 500 index as measured by the performance of the Vanguard 500 Index fund (VFINX) is down 13.2% for the first 11 months of the year. The Vanguard Small Cap Index fund (NAESX) is down 12.5% for the year.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 13.9% versus the Vanguard 500 Index fund’s gain of 9.8% per year on average over the same period. Over the same period, the Vanguard Small Cap Index fund also posted an average annual gain of 9.8% (Figure 1).

Stock Deletions and a Rule Change

The Model Shadow Stock 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.

The primary Model Shadow Stock Portfolio selection criteria target the intersection of the smallest 10% of domestic stocks as measured by market capitalization, 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 then applying the size and value breakpoints for stocks listed on all domestic exchanges.

Value Factor: No Deletions

The price-to-book cutoff has decreased slightly from 0.88 in September to 0.84 at the beginning of December. The current initial qualifying maximum price-to-book ratio for the model portfolio is 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. Stocks in the model portfolio are sold for valuation if they exceed three times the initial maximum price-to-book ratio at the time of a quarterly portfolio review.

No stocks in the Model Shadow Stock Portfolio exceeded the maximum price-to-book ratio at the time of review.

Size Factor: One Deletion

We also examined the market-cap levels of the companies listed on the NYSE to determine the size cutoff for the lowest decile when adding stocks to the model portfolio. The decile market-cap level declined from $330 million in September to $300 million. Therefore, the maximum initial qualifying market-cap value for the model portfolio has been reduced from $350 million to $300 million. Stocks with a market cap of $300 million and below are considered. Holdings are sold if their market cap goes above three times the initial criterion at the time of the quarterly review: $900 million.

Deletion: Perion Network Ltd. (PERI)

Perion Network exceeded the market-cap sell cutoff of $900 million with a market cap of $1.155 billion and was removed from the portfolio. Perion Network was purchased on December 13, 2019, at a price of $5.36 per share. It was sold on December 12, 2022, for $25.385 per share, for a gain of 373.5%.

Earnings Rule: Two Deletions

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 sold. When available, adjusted (non-GAAP) earnings are used to put stocks on probation or sell them.

Deletion: Dixie Group Inc. (DXYN)

Dixie Group went on earnings probation after reporting a loss of $0.29 per share for its 2022 second quarter. On November 3, 2022, Dixie Group reported a quarterly loss of $0.55 per share for its third quarter, while still on earnings probation. Dixie Group was purchased on September 9, 2021, at an average cost of $4.50 per share. It was sold on December 12, 2022, for $1.06 per share, for a loss of 76.4%.

Deletion: Ultralife Corp. (ULBI)

Ultralife went on earnings probation after the first quarter of 2022. The company reported positive quarterly earnings for the second quarter but a loss of $0.01 per share during the third quarter, while still on earnings probation. Ultralife was purchased on March 8, 2021, at a purchase price of $6.76 per share. It was sold on December 12, 2022, for $4.31 per share, for a loss of 36.2%.

Age Rule: One Deletion

We also examine the portfolio for stocks that have been held for at least four years and have not had strong price appreciation. We normally remove holdings that no longer qualify and have not gained at least 10% annually. However, with the recent bear market environment, we limited our examination to portfolio holdings held longer than four years and that are down from their original purchase price.

Deletion: Delta Apparel, Inc. (DLA)

Delta Apparel was added to the Model Shadow Stock Portfolio on August 31, 2017, at a purchase price of $20.01 per share. It hit a high of $35.26 during April 2021 but saw its share price come under pressure this year as the firm responded to labor shortages, inflationary pressures and supply chain disruptions. Delta Apparel has been held for just over 5.25 years, is down from its purchase price and does not currently qualify. It was sold on December 12, 2022, at $11.20 per share, for a loss of 44.0%.

Quarterly Additions

As of December 12, 30 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 at www.aaii.com/model-portfolios. The list of new Shadow Stock Ideas is updated daily—Tuesday through Saturday.

Ten qualifying stocks were already in the Model Shadow Stock Portfolio at the time of the review. The remaining 20 qualifying 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 sales, as well as the cash held in the portfolio, a position in six companies was able to be taken at roughly the average position size for the existing holdings in the tracking portfolio. The portfolio additions are: Clarus Corp. (CLAR), Core Molding Technologies Inc. (CMT), Escalade Inc. (ESCA), Friedman Industries Inc. (FRD), Lazydays Holdings Inc. (LAZY) and Mistras Group Inc. (MG).

Table 1 shows the current holdings in the Model Shadow Stock Portfolio, and Table 2 summarizes the changes made this quarter.

Clarus Corp.

Clarus is a leading developer, manufacturer and distributor of best-in-class outdoor equipment and lifestyle products focused on the climb, ski, mountain and sport markets. Clarus has a book value per share of $9.72 as of September 30. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $8.75 per share ($9.72 (CLAR) 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 $9.72 per share. To calculate the maximum purchase price based on the maximum desired price-to-book ratio, multiply the current book value per share ($9.72 for Clarus) 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).

Core Molding Technologies, Inc. 

Core Molding Technologies operates in the engineered materials market as a molder of thermoplastic and thermoset structural products. Core Molding Technologies has a book value per share of $12.92 as of September 30. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $11.63 per share ($12.92 (CLAR) 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 $12.92 per share.

Escalade Inc. 

Escalade designs, manufactures and sells sporting goods, fitness and indoor/outdoor recreation equipment. Escalade has a book value per share of $11.57 as of October 1. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $10.41 per share ($11.57 (CLAR) 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 $11.57 per share.

Friedman Industries Inc. 

Friedman Industries is a manufacturer and processor of steel products in two segments: coil products and tubular products. Friedman Industries has a book value per share of $14.73 as of September 30. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $13.26 per share ($14.73 (CLAR) 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 $14.73 per share.

Lazydays Holdings Inc. 

Lazydays Holdings operates recreational vehicle (RV) dealerships and offers a portfolio of products and services for RV owners and outdoor enthusiasts. Lazydays Holdings has a book value per share of $20.85 as of September 30. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $18.77 per share ($20.85 (CLAR) 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 $20.85 per share.

Mistras Group Inc. 

Mistras Group is a multinational provider of integrated technology-enabled asset protection solutions, helping to maximize the safety and operational uptime for critical industrial and civil assets. Mistras Group has a book value per share of $6.23 as of September 30. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $5.61 per share ($6.23 (CLAR) 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 $6.23 per share.

Next Portfolio Review

The next quarterly review of the Model Shadow Stock Portfolio will take place following the end of February 2022. 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).