AAII’s Model Shadow Stock Portfolio is based on data showing an advantage to investing in small and deep-value stocks. Research conducted by Nobel laureate Eugene Fama, Dartmouth professor Kenneth French and others has shown that portfolios comprising small value stocks outperform over the long term.

Underlying the Model Shadow Stock Portfolio are two key criteria: a small market capitalization and a low price-to-book-value (P/B) ratio. The price-to-book ratio must not be higher than approximately the 10% most cheaply valued stocks listed on the New York Stock Exchange (NYSE). The market cap must be no larger than approximately the smallest 10% of all NYSE-listed stocks. These limits reflect research showing that the value and size premiums are the strongest among stocks ranking in the bottom deciles for each factor.

The thresholds are used to establish market-cap (size) and price-to-book (valuation) limits for identifying candidates for the Model Shadow Stock Portfolio. The maximums are currently a market cap of $300 million and a price-to-book ratio of 0.90.

Neither threshold is static. Rather, they are periodically adjusted based on prevailing market conditions. The chart here shows how both metrics have evolved over the past 30 years. (The Model Shadow Stock Portfolio was launched in June 1993.)

The lowest ceiling for the smallest size decile was a market cap of $60 million in 1994. It rose to as high as $479 million in 2021. As you may notice, this threshold largely has stayed below $400 million on a year-end basis over the past 30 years.

The lowest ceiling for the cheapest valuation decile was a price-to-book ratio of 0.50 in December 2000. The highest price-to-book ratio for the lowest (cheapest) decile of NYSE-listed stocks was 1.20 in 2004. The threshold nearly reached this level again in December 2006 when it was 1.19.

Investors with a preference for deep-value and/or micro-cap stocks can use these thresholds as starting points to find such stocks. The Model Shadow Stock Portfolio overlays an earnings requirement, a minimum share price of $4 and a few other criteria to narrow down the field of candidates. You can see the full rules at www.aaii.com/model-portfolios.

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