• AAII Model Portfolios
  • Higher Prices Prompt Rule Change in the Model Shadow Stock Portfolio

    by James B. Cloonan

    Higher Prices Prompt Rule Change In The Model Shadow
Stock Portfolio Splash image

    While the market in general keeps approaching and then backing off new highs, the Model Shadow Stock Portfolio has broken through and is now up 28.5% year-to-date as of November 30, 2012. This compares to 14.8% for the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX). The returns for longer periods can be seen in Figure 1 and Table 3.

    The presidential election is over, and we are spared the media barrage of negative comments. We do have the fiscal cliff debates and speeches, which seem to be affecting the stock market for about an hour at a time. I hope that problem will be mostly resolved by the time you read this column, but who knows.

    I am not a technician, but I certainly have the feeling that the market wants to go up. Even with the mess in Washington and the threat of a serious negative impact on the economy if something isn’t done about taxes and spending, the market hangs in. With billions on the sidelines and in very low yield bonds, there is certainly the scenario for a strong stock market even though post-election years have historically had the weakest average returns of the four-year presidential cycle.

    Portfolio Rule Change

    Table 1 lists the current holdings in the Model Shadow Stock Portfolio.

    Standex International Corp. (SXI) would have been sold based on its market capitalization being over $600 million, but we have raised the market-cap criterion. Stocks must now have a market cap between $30 million and $240 million to be considered for purchase. Therefore, the sell requirement of three times the initial maximum market cap moves up to $720 million. Stocks will be marked as approaching the size limit if they reach $600 million, 2½ times the initial maximum market cap. The increase in the price of micro-cap stocks required this adjustment.

    Since we had no stocks that needed to be sold in our fourth-quarter review, there are no buy transactions this period, as shown in Table 2.

    There were 18 qualifying stocks under our liquidity criterion as well as the new market-cap criterion, as shown in Figure 2. Of these, two were already owned and three were Chinese stocks, which we continue to avoid.

    Micro-Cap Performance

    The Model Shadow Stock Portfolio has been doing extremely well since the 2007–2008 bear market, considerably better than the overall market and various subindexes.

    Company (Ticker) Current
    52-Week Market
    ($ Mil)
    Addus Homecare Corp. (ADUS) 6.78 6.90 3.00 73.3 11.5 0.81 0.0  
    Alamo Group, Inc. (ALG) 33.12 34.63 25.51 396.3 12.4 1.29 0.7  
    Capital Senior Living Corp. (CSU) 17.81 18.00 6.70 501.8 nmf 2.87 0.0 approaching value limit
    CSS Industries, Inc. (CSS) 20.52 22.4 17.86 196.5 13.0 0.81 2.9  
    Ducommun Incorporated (DCO) 15.67 15.89 7.71 166.0 nmf 0.76 0.0  
    Ennis, Inc. (EBF) 15.22 17.74 12.80 398.1 18.3 1.09 4.6  
    Flexsteel Industries (FLXS) 19.89 23.28 13.26 139.4 10.4 0.97 3.0  
    Gilat Satellite Networks (GILT) 5.26 5.60 2.31 217.2 nmf 0.82 0.0  
    Hardinge Inc. (HDNG) 9.59 11.65 7.61 112.1 8.4 0.70 0.8 qualified as of 11/30/2012
    Hooker Furniture Corp. (HOFT) 13.89 14.25 9.30 149.3 27.8 1.18 2.9  
    Key Tronic Corp. (KTCC) 10.14 13.16 4.40 106.4 7.7 1.27 0.0  
    Kimball International (KBALB) 12.48 13.25 5.03 475.2 28.4 1.21 1.6  
    Marlin Business Services (MRLN) 17.30 23.08 12.39 220.4 21.9 1.23 1.8  
    Medical Action Industries (MDCI) 2.69 6.36 2.25 44.1 nmf 0.30 0.0  
    Mitcham Industries (MIND) 14.49 26.76 12.39 186.1 6.0 1.07 0.0  
    Olympic Steel, Inc. (ZEUS) 19.77 28.31 14.77 215.8 16.8 0.72 0.4  
    PC Connection, Inc. (PCCC) 10.60 12.92 7.34 281.0 8.9 0.94 0.0  
    PC Mall, Inc. (MALL) 5.93 6.70 5.06 71.1 31.2 0.62 0.0 qualified as of 11/30/2012
    RCM Technologies, Inc. (RCMT) 5.75 6.16 4.89 69.2 22.1 0.99 0.0  
    Renewable Energy Gp (REGI) 5.92 10.65 4.28 180.7 2.2 0.53 0.0  
    REX American Resources (REX) 18.84 33.95 14.43 155.2 8.1 0.62 0.0 qualified as of 11/30/2012
    Rocky Brands, Inc. (RCKY) 13.31 14.33 8.75 99.9 15.1 0.81 0.0  
    Saga Communications (SGA) 45.35 47.98 33.53 192.7 11.8 1.83 0.0  
    Shoe Carnival, Inc. (SCVL) 22.11 24.66 14.97 452.4 15.2 1.41 0.9  
    Standard Motor Products (SMP) 19.56 25.91 11.94 446.3 6.8 1.46 1.8  
    Standex Int’l Corp. (SXI) 49.26 52.14 31.60 626.9 13.4 2.42 0.6 approaching size & value limits
    Sterling Construction (STRL) 9.23 12.42 7.12 152.3 nmf 0.72 0.0 earnings probation (2012 Q2)
    VOXX International (VOXX) 6.74 14.56 5.55 157.7 8.4 0.38 0.0 qualified as of 11/30/2012
    Willis Lease Finance (WLFC) 14.33 14.82 10.75 127.0 nmf 0.59 0.0  

    Explanation of Notes

    Approaching Size Limit: Stocks are sold if their market capitalization goes above three times the initial maximum criterion. The current market capitalization maximum for initial screening is $240 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $600 million.

    Approaching Value Limit: Stocks are sold once their price-to-book-value ratio goes above three times the initial criterion. The current initial price-to-book ceiling is 0.80. Stocks are marked “approaching value limit” if their current price-to-book-value ratio exceeds 2½ times the initial criterion, or 2.00.

    Earnings Probation: If the last 12 months’ earnings from continuing operations 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. The date within the parentheses lists the fiscal quarter during which the company first reported negative trailing 12-month earnings.

    Qualified 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.

    See the Model Shadow Stock Portfolio area of AAII.com for more information.

    It is a little perplexing that small stocks in general have not outperformed and value stocks have been lagging growth stocks this period. The only explanation I can think of is that micro caps as we have defined them are different than small caps, which many define as having market capitalization up to $2 billion or more. Also, we have a rather strict definition of value (price-to-book-value ratio less than 0.80), while value stocks as defined in most indexes cover the half of all stocks in a category with the lowest price-to-book ratio. This often includes price-to-book levels of 2.0 or more.

    Company (Ticker) Reason
    No buys for fourth quarter.  
    No sells for fourth quarter.  
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    Table 3. Model Shadow Stock Portfolio: Annual Performance

    Year Average Annual Return (%) Cumulative Value of $10,000 ($)
    Small Cap
    Small Cap
    1993 32.3 9.9 18.7 13,230 10,989 11,870
    1994 2.0 1.2 -0.5 13,492 11,118 11,810
    1995 20.7 37.4 28.7 16,291 15,282 15,204
    1996 22.3 22.9 18.1 19,927 18,775 17,959
    1997 44.3 33.2 24.6 28,756 25,010 22,375
    1998 -8.9 28.6 -2.6 26,188 32,168 21,790
    1999 0.0 21.1 23.1 26,187 38,945 26,831
    2000 -7.7 -9.1 -2.7 24,163 35,418 26,116
    2001 21.4 -12.0 3.1 29,325 31,160 26,926
    2002 10.8 -22.1 -20.0 32,506 24,259 21,535
    2003 73.1 28.5 45.6 56,268 31,174 31,360
    2004 43.7 10.8 19.9 80,843 34,530 37,587
    2005 17.9 4.8 7.4 95,353 36,180 40,376
    2006 29.4 15.6 15.6 123,363 41,832 46,687
    2007 -1.8 5.4 1.2 121,166 44,083 47,227
    2008 -50.8 -37.0 -36.0 59,582 27,764 30,217
    2009 72.3 26.5 36.1 102,665 35,120 41,130
    2010 45.4 14.9 27.7 149,238 40,358 52,529
    2011 6.3 2.0 -2.8 158,701 41,155 51,067
    YTD 28.5 14.8 14.5 203,895 47,241 58,479
    Since Incep 16.3 8.1 9.3 203,895 47,241 58,479


    The numbers shown here may differ from your results depending on your requirement for average daily trading volume.

    Looking Ahead

    As I mentioned, I have a slightly bullish bias, but would not suggest any deviations from a long-term allocation. While the average low return of post-election years since the 1930s is 6.7%, there have been some notable exceptions. In fact, four years ago the return on the S&P 500 was 26.5% and the return on this portfolio was 72.3%. In addition, all the major averages are below their all-time highs, which is certainly bullish for the long term, if not the short term.

    If the fiscal cliff has been bridged by the time you read this, at least that variable will be put to rest. Of course, looking around the world we still have plenty of variables to be concerned about. We will review the portfolio again in the April 2013 AAII Journal; until then, you can keep abreast here.

    Model Shadow Stock Portfolio Rules

    Purchase and Sales Rules

    Stock purchases must meet these criteria:

    • No bulletin board or pink sheet stocks will be purchased.
    • Price-to-book-value ratio must be less than 0.80. (Figure will change gradually with changes in overall market values.)
    • Market capitalization must be between $30 million and $240 million. (Figure will change gradually with changes in overall market values.)
    • The firm’s last quarter and last 12 months’ earnings from continuing operations must be positive.
    • No financial stocks or limited partnerships will be purchased.
    • No stocks on foreign exchanges or ADRs will be purchased because of different accounting and/or withholding tax on dividends.
    • The share price must be greater than $4.
    • In order to reduce trading by avoiding stocks that are forever marginal, any stock that was sold within two years will not be rebought.
    • Note second item under Stock Order Guidance concerning spreads when buying shares.
    • Price-to-sales ratio must be less than 1.2. (Figure may change gradually with changes in overall market values.)
    • Eliminate any company that failed to file a 10-Q (quarterly) report in the last six months.

    Stocks are sold if any of the following occur:

    • If last 12 months’ earnings from continuing operations are negative, the stock is put on probation; if a subsequent quarter has negative earnings prior to 12-month earnings from continuing operations becoming positive, the stock is sold.
    • The stock’s price-to-book-value ratio goes above three times the initial criterion.
    • Market capitalization goes above three times the initial maximum criterion.

    Stock Order Guidance

    • These rules are for general guidance. Your own experience, market conditions and the size of the position will impact your own decisions. The results in the model portfolio were obtained while sometimes paying more.
    • Market orders are not used. Instead, if the quoted bid-ask spread is less than 2% (ask price minus bid price, divided by ask price), place a limit order at the ask price for a buy and at the bid price for a sell. If the bid-ask spread is more than 2%, try to place a limit order between the bid and ask prices to keep transaction costs low. If necessary, build a position gradually. With low commissions, it is often better to place partial orders than to try to establish a large position all at once. Be patient.
    • The average daily dollar volume should be at least four times the amount needed for your position. This will ensure liquidity to get in and out of the position, even if you need to grow the position gradually and sell gradually. This will result in a varying number of qualifying stocks for each investor.
    • For NASDAQ stocks, it appears to be better to use day orders. If the order is not filled, it is placed again with a slight adjustment. For NYSE and Amex stocks, good-till-canceled (GTC) orders are used to keep a place in line in the specialists’ books. If the market isn’t close to the desired price, the price is adjusted in a few days with a new GTC order.
    • If price changes cause a stock to become ineligible (due to changes in price-to-book-value ratio or market capitalization) when only part of the order has been filled, stocks already purchased are kept but the balance of the order is canceled.

    Management Rules

    • Equal dollar amounts are invested in each stock initially.
    • Decisions are made only at the end of each quarter. In order to react to the majority of earnings reports as soon as possible, quarterly reviews are made in February, May, August, and November.
    • Best judgment is used for tenders or mergers, but all criteria must be obeyed.
    • At the end of a quarter, if receipts from stocks sold exceed requirements for new purchases, the excess receipts—up to 5% of the portfolio’s value—are kept in cash until the next quarter. If the excess receipts are greater than 5% of the total portfolio value, the amount above 5% is distributed to smaller holdings that still qualify as buys. Efficient quantities are purchased: If over 10% of the portfolio is in cash, the price-to-book-value ratio can be moved up, but never over 0.90.
    • At the end of a quarter, if receipts from stock sales are insufficient to buy all newly qualifying stocks, purchases are made in order of lowest bid/ask spreads.
    • Note that if you are managing your own portfolio, it should consist of at least 10 stocks. If you are developing the portfolio gradually, you can do it stock by stock, but don’t put more than 10% of your funds in each additional stock. More than 20 stocks is not needed until the portfolio exceeds $1 million.


    Chett Maruyama from HI posted over 3 years ago:

    Is it possible to enter or post the date the stock has been posted? something to refer back to.

    Thank you
    keep up the good pick

    Robert Warnock from CA posted over 3 years ago:

    The annual returns of the Shadow Stock Portfolio seem impressive, but from the management rules as stated it is impossible to know what these figures actually mean. Do they refer to the actual portfolio as it has evolved, or to something else, perhaps a periodically balanced portfolio of qualifying stocks? If the former, how are we to know the amounts of each position in the portfolio? The rules for the initial portfolio and for selling are fairly definite, but the rules for investing proceeds of sales are highly indefinite. For instance, what are the "requirements for new purchases" mentioned in Management Rules? Shouldn't we at least be told the weights of the various positions in the current portfolio?

    Martin Blackman from IL posted over 3 years ago:


    Charles Crowley from FL posted over 3 years ago:

    Very informative.....

    John Steinmetz from CA posted over 3 years ago:

    I have not been getting the weekley updates/ What do I need to do?

    Bruce Jacobson from TN posted over 3 years ago:

    I have been recording Cash Flow for potential stocks. However some stocks that look very good have negative CF. How much weight should you give Cash Flow?

    Glenn Rawls from FL posted over 3 years ago:

    Table 2 showed no transactions for the 4th qt.
    However, the portfolio showed 4 stocks that qualified on 11/30/12. Why the contradiction?

    Jean Henrich from IL posted over 3 years ago:

    Chett - Click on Transaction History on the right side of the Shadow Stock Portfolio page for the dates when stocks were added: http://www.aaii.com/model-portfolios/stock-transaction-history.

    Robert - The performance shows actual returns our chairman, Jim Cloonan, has achieved using the Shadow Stock approach; he holds the stocks shown in the portfolio here. There's a detailed history page at the above-mentioned Transaction History link that shows exactly how many shares he purchased. But for anyone starting a Model Shadow Stock Portfolio today, equal dollar amounts should be put into each stock chosen initially. The portfolio is not rebalanced, but when new stocks are added, you can simply calculate a new average investment amount based on your total investment and the number of stocks you hold.

    John - There are no weekly updates on the portfolio, but updates are sent out monthly. Go to My Account at the top right corner of this page to subscribe to the free monthly Model Portfolios Update email.

    Bruce - The portfolio rules don't address cash flow, but you can use it as a secondary factor when you are investigating the Shadow Stocks, if you you wish. You can find articles in our archives on cash flow as a selection criteria in stock investing approaches and how to analyze cash flow by using the search tool at our home page.

    Glenn - Stocks that are already in the actual portfolio are marked "qualified as of" to show members who are starting out which stocks currently meet the purchase rules. Since these stocks were not newly added to the portfolio, they are not shown as fourth-quarter transactions. (Again, see the Transaction History page for when each stock was originally bought.) At this point, since our chairman has the actual portfolio at a size that he is comfortable with, he doesn't add new stocks unless he sells stocks in his quarterly review and frees up funds for new purchases.

    --Jean at AAII

    Antonio Gomez from CA posted over 3 years ago:

    No Comment

    E Birnbaum from NM posted over 3 years ago:

    Regarding the label "qualified as of", would that statement be a good basis for adding to a position, or is it more important to keep the portfolio balanced?

    Jean Henrich from IL posted over 3 years ago:

    E - Keeping the portfolio balanced would outweigh adding to a position

    -Jean from AAII

    William Millhiser from TN posted over 3 years ago:

    The canned shadow stock screen in Stock Investor Pro still seems to be screening for market caps between $17M and $240M. I'm under the impression Mr. Cloonan has raised the lower number to $30M for qualifying companies. Did I miss something? Developed my own screen at $30M and it makes a difference.

    Rob Capellini from NY posted over 3 years ago:

    First -- thank you for providing this service. The performance charts are truly impressive. Could you please discuss in a little more detail the following questions:

    1) How is the market capitalization range derived? How was the minimum of $30M derived? How was the maximum of $240M derived?

    2) How one decides on the price-to-book value ratio? Why is 0.8 a good number, based on current market conditions?

    3) How one determines the price-to-sales criterion? What makes 1.2 the right number?

    4) What would prompt one to revise the market cap, price-to-sales, or price-to-book criteria? James mentions that the adjustment in the market cap criterion is because micro-cap stocks have risen in price. Is there a more definitive quantitative criteria for determining the specific ranges of values?

    Thank you again for providing this service and thank you in advance for answering my questions.

    Chuck Esposito from UT posted over 3 years ago:

    i don't understand the sell rule for getting over 3 times initial plurchase making any sense.

    Vaidy Bala from AB posted over 3 years ago:

    I am new to this site. From 1993 to 2011 the total return is some 16.3 %. I notice practically no dividends except a couple. So, my assumption the total return every year is about 16 % comes purely from price change. Plus the standard deviation is also high. Is this portfolio you recommend for retired investors who are looking for income today?
    thanks, I will wait to read your comments.

    Charles Rotblut from IL posted over 3 years ago:

    Hi Vaidy,

    The Model Shadow Stock portfolio is focused on capital appreciation, not generating dividend income. It invests in micro-cap stocks, which tend not to pay dividends and can be more volatile. You should consider the year-b-year volatility to determine whether you would be willing to stick with the portfolio in both bull and bear markets: http://www.aaii.com/model-portfolios/stock-annual

    If income generation and less volatility is what you seek, we do offer a premium newsletter, AAII Dividend Investing. This is a hand-picked portfolio of 24 dividend-paying stocks. Though we do focus on total return (price appreciation and dividend income), the portfolio is less volatile than the Shadow Stock portfolio. You can find out more information about it at http://www.aaiidividendinvesting.com/ or by clicking on the "Dividend Investing" tab at the top of the page.

    I hope this helps,

    Scott Youngquist from OH posted over 3 years ago:

    Price to Book sell rules. Is the valuation rule of 3 times the initial price-to-book valuation a rule or a guideline? There are stocks like CSU and SXI that have exceeded a PB of 2.4 (3x0.8) and have not been sold. I am setting up Stock Investor Pro screens to track when to sell and I am not sure how to use the price-to-book ratio.

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