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AAII Model Portfolios Small Cap Value Investing Value Investing

Examining the Shadow Stock Value and Size Factors

Our model portfolio is one of the oldest real-money examples of how the value and size premiums can be combined into a single strategy.

by John Bajkowski | September 2018

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Factor investing has become a popular way to seek out excess returns.

At its best, factor investing is a systematic investment strategy supported by long-term empirical evidence that can be explained with economic and behavioral insight. The empirical evidence should be pervasive and expected to continue into the future. Common factors used today include value, momentum, size, quality, volatility and carry (yield).

Some investors focus on single factors to create their portfolios, like looking for the A students who excel in a specific subject. However, many investors seek to combine factors that are unrelated (negative or low correlations) but when combined contribute to more consistent performance, higher returns or lower risk.

Multi-factor approaches are akin to well-rounded students who achieve consistently high grades across a wide range of subjects, even if they don’t always get A grades.

A Classic Two-Factor Portfolio

The Model Shadow Stock Portfolio is one of the oldest real-money examples of constructing and managing a two-factor portfolio focused on value and size. The Model Shadow Stock Portfolio was started in January 1993 to show members how a consistent investment approach could be followed and to help them learn how to apply it in their own portfolios.

Table 1 shows the stocks that currently make up the portfolio.

The genesis for the creation of the Model Shadow Stock Portfolio was research from Eugene Fama and Kenneth French. Their oft-cited study, “The Cross-Section of Expected Stock Returns” (1992), found that company size, as measured by market capitalization, helped explain future market returns.

Market capitalization, or market cap, is simply calculated by multiplying the number of shares a company has issued by the share price. It is a common measure of company size and represents the market consensus of a company’s worth. Apple Inc.’s (AAPL) market cap is just above $1 trillion, while a number of smaller companies that trade on stock exchanges have a market cap of just a few million dollars.

The stocks with the lowest market cap outperformed the largest companies by a wide margin between July 1963 and December 1990. As shown in first column of Table 2, stocks in the lowest decile on average returned 19.1% a year versus 11.2% for the largest market-cap decile.

Table 1. Model Shadow Stock Portfolio

Table 1. Model Shadow Stock Portfolio

Notes

Approaching Size Limit: Stocks are sold if their market capitalization goes above three times the initial maximum criterion and there is a stock to replace it. The current market capitalization maximum for initial screening is $400 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $1 billion.

Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above three times the initial criterion and there is a stock to replace it. The current initial price-to-book ceiling is 1.00. Stocks are marked “approaching value limit” if their current price-to-book-value ratio exceeds 2½ times the initial criterion, or 2.50.

Earnings Probation: 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 becoming positive, the stock is sold. When available, adjusted (non-GAAP) earnings are used to put stocks on probation or sell them. Otherwise, earnings from continuing operations are used. The date is the fiscal quarter during which the company first reported negative trailing 12-month earnings.

Qualifies as of: Stock still qualified as a buy when the screen was run with current data. Stocks that don’t currently qualify as a buy are held until they meet one of the sell rules.

Researchers often rank domestic companies listed on the New York Stock Exchange (NYSE) by various factors to determine and record the different breakpoints that are then applied to stocks listed on other exchanges as well. This is done to maintain continuity over time when looking at market data before the growth of Nasdaq. Kenneth French maintains a useful data library on his Dartmouth College webpage (http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html).

Fama and French’s research also found that companies with the lowest price-to-book-value ratios (P/B) performed better than those with high measures. The price-to-book-value ratio is calculated by dividing share price by shareholder’s equity. The lowest price-to-book-value stocks, on average, returned 21.4% a year versus 8.0% for those with the highest price-to-book-value ratios as shown in the first row of Table 2.

Table 2. Returns of Stocks Grouped by Market-Cap Size and Price-to-Book Ratio

Table 2. Returns of Stocks Grouped by Market-Cap Size and Price-to-Book Ratio

A Multi-Factor Strategy

Taken individually, company size and valuation are factors investors can use to select stocks that, historically, have outperformed the broader market. However, they capture different elements or factors. What Fama and French discovered in their research is that, when combined, micro cap and low price to book value yield even better performance, as illustrated in Table 2.

An approach that combines the lowest decile by market cap and lowest decile by price to book value earned 25.6% per year on average versus 19.1% for the lowest market-cap decile, 21.4% for the lowest price to book value and 15.8% for the complete stock universe. The return of this combined portfolio is highlighted in the lower right-hand corner of Table 2.

The primary Model Shadow Stock Portfolio selection criteria target the value and size intersection, but the breakpoints that determine the NYSE deciles change over time. Table 3 provides a history of the size and value maximums used to manage the Model Shadow Stock Portfolio. The initial $55 million market-cap maximum for inclusion in the Model Shadow Stock Portfolio has grown to $400 million. The price-to-book-value ratio has fluctuated as well. It was lowest during 2001 and 2002, at 0.60, and is currently at its highest level of 1.00.

Table 3. Size and Value Maximums Used for the Model Shadow Stock Portfolio

Table 3. Size and Value Maximums Used for the Model Shadow Stock Portfolio

The high price-to-book valuation levels reflect the long and aging bull market. However, as noted in the May 2018 AAII Journal, successfully timing the market involves determining when to get out of the market as well as when to get back in. Missing the best market upturns often hurts long-term performance more than avoiding a portion of a bear market.

We will report on any quarterly portfolio actions for the Model Shadow Stock Portfolio in the October AAII Journal. You can follow the portfolio on AAII.com in the Model Portfolios area. To receive monthly email updates along with alerts to any changes made to the portfolio, please sign up at www.aaii.com/email.

Discussion

Thomas Eberhard from MN posted over 7 years ago:

What happened to VPG on the Model Shadow Stock Portfolio?


Wayne Thorp from IL posted over 7 years ago:

@Thomas, VPG is still in the Model Shadow Stock Portfolio.


Jim Nakos from NM posted over 7 years ago:

I've been looking at and investing in the Shadow stock portfolio for some years now. Looking at the long term performance graph it looks like the Shadow stock portfolio really began to distance itself from the indices on about 2002-2003. Returns look better. I don't recall any fundamental changes to the selection criteria because I was not following it closely back then. Can you provide any insight as to what might have occurred during that time period that resulted in the shadow stock portfolio to began showing better returns? Thanks Jim Nakos


Steven Riggs from KY posted over 7 years ago:

I understand the factors we use but is there any kind of narrative about each company and their operations? Any special characteristics or ideas on why they are a good pick other than the factors?


Dave Gilmer from WA posted over 7 years ago:

@Jim, Actually, I would like to know just the opposite -- why has the Portfolio underperformed the S&P500 in 4 of the last 5 years including 2008? Is it just out of favor, or is a long-term trend developing?


James Critchley from MA posted over 7 years ago:

I'm a newly minted AAII member and I can't seem to register myself for the discussion boards - looks like a website problem. Here's a question about this topic I wish I could have posted there. I’m new to AAII and have started a shadow stock portfolio of my own, populating it last week with stocks from the current “Passing Companies” list. Although this is all new to me, I feel I understand the basic investment strategy of this approach, but I have a couple of questions about the rules for when to sell. Actually, it’s the same question but it concerns two similar rules. The price / book ratio rule for selling says “three times the initial criterion” used for stock selection. Today, the selection rule says to buy a stock it must have a price / book ratio less than 1.0 – but there’s a caveat that states the criterion may change over time. Similarly, the market cap rule for selling is “three times the initial maximum criterion” used for stock selection. For stock selection, today’s market cap rule is that a stock must have a market cap between $30M and $400M. So for selling, the market cap rule today is to sell when the company reaches a market cap greater than $1.2B. But here again there is the same caveat that this maximum may change over time. So, my question is this. As my portfolio ages, these 2 criteria above for buying are likely to change – perhaps several times (remember I have zero experience or knowledge of the history of changes in these rules). As I hold these stocks, should I ignore the any changes that may have occurred to the buy rule criteria and sell when a stock I picked today reaches a price / book ratio greater than 3.0 (or a market cap greater than $1.2B) or (years down the road) should I use the then current revised buy rule criteria to determine when to sell? Anyone with experience using these rules for the shadow stock portfolio - please answer this. I want to follow the rules as they are intended to be followed to achieve the kind of results expected but I can’t discern which interpretation is correct. Also, I’m setting up a spreadsheet to help me monitor the portfolio and it seems that if new changes to the buy rule criteria should not be used for determining when to sell an old stock, I need a way of recording what the sell criteria should be for each stock I buy at the time I add it to the portfolio. Otherwise, I will not know the correct criteria to apply and I’ll be forced to use whatever values for the rules are currently being published, whether correct or not.


James Critchley from MA posted over 7 years ago:

Does anyone read these comments? I'd like to know about the shadow stock portfolio rules for selling. Should I use the price/book and Market cap criteria in effect when I bought the stock or should I use the current criteria if they have changed? Thanks!!


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