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AAII Model Portfolios Small Cap Value Investing

Model Shadow Stock Portfolio: Insights and a New Stock

To realize the higher long-term returns of small-cap value stocks, some periods of short-term underperformance have to be endured.

by Wayne A. Thorp, John Bajkowski | April 2018

Wayne Thorp leads a class in AAII's new Essential Investing Video Course. Go to https://www.aaii.com/ves for more information and to subscribe.

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Investing is not always easy.

A great deal of research supports the notion that over the long term, stocks of smaller companies have had greater returns than those of larger companies. The research also shows that low price-to-book-value ratio stocks have had higher returns over the long term than glamour (high price-to-book-value) stocks—and this was in addition to any smallness effect. The Model Shadow Stock Portfolio was designed to capture the benefit of these observations.

To realize those higher long-term gains, however, you have to be willing to expect some periods of underperformance. You also have to be able to accept greater short-term volatility from small-cap stocks, with the understanding that your long-term wealth accumulation should benefit from your patience.

So far, 2018 is certainly testing the patience of small-cap value investors. As of February 28, 2018, the Model Shadow Stock Portfolio was down 9.3% year to date, compared to a 1.8% gain for the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX). The Vanguard Small Cap Index fund (NAESX) is down 1.3% year-to-date. Figure 1 provides a chart of long-term performance along with compound annual returns, while Table 3 provides a year-by-year history of the performance of the Model Shadow Stock Portfolio.

Figure 1. Model Shadow Stock Portfolio vs. Benchmarks
(Through 2/28/2018)

Figure 1. Model Shadow Stock Portfolio vs. Benchmarks (Through 2/28/2018)

 

 

 

 

 

 

 

 

 

 

 

The portfolio’s performance this year has been influenced by significant declines of a handful of holdings, most of which still qualify under the value and size rules for being added to the portfolio. The Model Shadow Stock Portfolio reflects the philosophy that success comes more from concern for the overall portfolio than for individual stocks. The portfolio rules focus on building a portfolio of stocks possessing the attractive characteristics as highlighted by sound academic research coupled with portfolio management rules aimed at controlling emotional behaviors that normally reduce long-term aftertax returns of managing a portfolio of micro-company stocks.

As noted by AAII founder James Cloonan when he started this model portfolio, for those willing to spend more time managing their portfolios, additional screens and quantitative analysis can be used. Keep in mind that research continually shows that, among individuals and professional investors alike, those with a consistent approach win and those who keep changing strategies lose.

Quarterly Portfolio Activity

Table 1 lists the stocks that currently make up the Model Shadow Stock Portfolio, and Table 2 summarizes the changes made during the quarterly update. After conducting our quarterly review of the Model Shadow Stock Portfolio at the end of February, none of the current Shadow Stock holdings met any of the portfolio’s sell rules in terms of earnings, price-to-book ratio or market capitalization. However, Hardinge Inc. (HDNG) announced that it had entered into a definitive merger agreement to be acquired by an affiliate of Privet Fund Management LLC for $18.50 per share in cash. Therefore, Hardinge was sold from the portfolio.

Table 1. Model Shadow Stock Portfolio

Company (Ticker) Current Price ($) 52-Week Market Cap ($ Mil) P/E Ratio (X) P/B Ratio (X) Div Yield (%) Notes
High ($) Low ($)
Aceto Corp. (ACET) 7.17 17.10 6.99 228.30 31.3 0.64 3.6 qualifies as of 2/28/2018
Amira Nature Foods (ANFI) 4.04 7.05 3.85 165.60 4.7 0.77 0.0 qualifies as of 2/28/2018
Autoweb Inc. (AUTO) 7.06 14.79 6.63 92.90 42.5 0.70 0.0 qualifies as of 2/28/2018
AV Homes Inc. (AVHI) 16.80 20.50 14.65 380.60 nmf** 0.88 0.0  
Beazer Homes USA (BZH) 15.72 23.24 11.18 551.00 37.5 0.91 0.0  
Big 5 Sporting Goods (BGFV) 6.15 17.10 5.05 127.50 20.9 0.64 9.8  
Container Store Group (TCS)* 5.05 6.37 3.53 242.00 61.6 0.96 0.0 qualifies as of 2/28/2018
CPI Aerostructures (CVU) 8.20 10.05 5.55 74.00 12.4 1.01 0.0  
CSS Industries Inc. (CSS) 18.41 30.29 18.41 173.40 nmf** 0.57 4.3  
Delta Apparel, Inc. (DLA) 18.05 23.47 15.55 140.00 12.0 0.92 0.0 qualifies as of 2/28/2018
Ducommun Incorporated (DCO) 28.14 35.58 25.06 322.70 24.0 1.41 0.0  
Ennis, Inc. (EBF) 19.50 21.50 15.20 512.20 15.6 1.90 4.1  
Flexsteel Industries (FLXS) 38.86 57.79 37.52 297.50 11.3 1.27 2.3  
Hallador Energy Co. (HNRG) 6.60 8.99 4.79 192.30 26.1 0.86 2.4 qualifies as of 2/28/2018
Hooker Furniture Corp. (HOFT) 37.35 52.75 29.75 445.20 14.2 1.96 1.5  
Kimball Electronics (KE) 17.35 22.45 15.05 473.70 14.3 1.36 0.0  
New Home Co. (NWHM) 11.24 13.55 9.75 243.20 13.8 0.89 0.0  
Olympic Steel, Inc. (ZEUS) 22.53 27.16 15.83 258.30 20.3 0.96 0.4 qualifies as of 2/28/2018
PC Connection, Inc. (CNXN) 24.83 30.48 22.66 684.60 14.2 1.42 0.0  
PCM Inc. (PCMI) 7.10 31.20 7.05 88.90 9.1 0.67 0.0  
RCM Technologies (RCMT) 6.36 6.55 3.89 77.60 49.9 2.25 0.0  
RCI Hospitality Holdings (RICK) 27.01 33.78 16.02 270.10 31.9 1.98 0.4  
Renewable Energy Group (REGI) 11.10 13.55 8.85 427.20 nmf 0.78 0.0 earnings probation as of 2017Q3
REX American Resources (REX) 80.72 107.87 72.71 544.70 16.1 1.47 0.0  
Roadrunner Transportation (RRTS) 3.83 9.75 3.52 154.10 nmf** 0.74 0.0  
Rocky Brands Inc. (RCKY) 18.40 20.95 10.25 136.90 21.5 1.00 2.4 qualifies as of 2/28/2018
Seneca Foods Corp. (SENEA) 29.10 39.45 27.75 296.40 40.1 0.65 0.0 qualifies as of 2/28/2018
SigmaTron International (SGMA) 7.10 11.61 4.01 31.10 12.9 0.47 0.0 qualifies as of 2/28/2018
Strattec Security Corp. (STRT) 34.20 49.20 23.00 133.70 12.5 0.80 1.6 qualifies as of 2/28/2018
Townsquare Media Inc. (TSQ) 6.96 13.01 6.28 129.50 10.9 0.32 0.0 qualifies as of 2/28/2018
Vishay Precision Group (VPG) 29.95 31.80 15.10 409.40 25.5 2.10 0.0  
na = not available
nmf = no meaningful figure
*new addition as of 3/9/2018.
**Trailing four-quarter GAAP earnings negative, but adjusted earnings positive.
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 2/28/2018.

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.

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

Table 2. First-Quarter 2018 Transactons

Sell
Company (Ticker) Reason
Hardinge, Inc. (HDNG) acquired by affiliate of Privet Fund Mgmt LLC
Buy
Company (Ticker) Maximum Price to Pay
Container Store Group (TCS) $5.23 (can be loosened to $5.75)

With the proceeds from the Hardinge sale and the existing cash position of the Model Shadow Stock Portfolio, there were enough funds to take a position in one company at roughly the average position size for the existing holdings in the tracking portfolio.

Ten stocks passed the screen based on the liquidity requirements at the time of the review, but the portfolio already held all but two stocks. The four-week relative strength price ranking was used to select the Container Store Group (TCS) for the Model Shadow Stock Portfolio.

Table 3. Model Shadow Stock Portfolio: Annual Performance

Year Average Annual Return (%) Cumulative Growth of $10,000 ($)
Model Shadow Stock Portfolio Vanguard 500 Index (VFINX) Vanguard Small Cap Index (NAESX) Model Shadow Stock Portfolio Vanguard 500 Index (VFINX) Vanguard Small Cap Index (NAESX)
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
2012 33.3 15.8 18.0 211,588 47,666 60,274
2013 61.0 32.2 37.6 340,599 63,009 82,966
2014 -5.8 13.5 7.4 320,844 71,516 89,105
2015 -15.2 1.3 -3.8 272,161 72,410 85,693
2016 29.8 11.8 18.2 353,261 80,964 101,248
2017 14.0 21.7 16.1 402,716 98,495 117,542
2018 YTD -9.3 1.8 -1.3 365,431 100,277 115,960
Since Incep 15.4 9.5 10.2 365,431 100,277 115,960
Data as of 2/28/2018.

Looking Ahead

James Cloonan introduced AAII members to the principles and rules of the Model Shadow Stock Portfolio in his January 1993 article that was simply titled “Thinly Traded Stocks: Putting a Practical Approach to the Test.” He felt that individual investors could effectively construct and manage a micro-cap portfolio and profit from the challenges that institutional investors faced competing in that segment of the stock market.

We thank James Cloonan for his contributions, and we pledge to continue in his steps of using curiosity, passion and intellect to “share with you the problems of dealing in thinly traded stocks.”

You can follow the Model Shadow Stock 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 go to www.aaii.com/email.

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 or equal to 1.00. (Figure will change gradually with changes in overall market values.)
  • Market capitalization must be between $30 million and $400 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 and, if there are earnings estimates, the estimates must be positive for the current quarter and year.
  • No financial stocks, including those in the rental & leasing industry, or limited partnerships will be purchased.
  • No utility stocks will be purchased.
  • No stocks on foreign exchanges or ADRs will be purchased due to different accounting and/or withholding tax on dividends. Foreign stocks traded primarily on U.S. exchanges are OK with one exception: The stock of any company whose primary business is in China will not be purchased.
  • 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.
  • Relative price strength over the last four weeks will be used as a tie-breaker.

Stocks are sold if any of the following occur:

  • 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 stock’s price-to-book-value ratio goes above three times the initial criterion and there is a stock to replace it.
  • Market capitalization goes above three times the initial maximum criterion and there is a stock to replace it.
  • The stock has been held for four years—unless it currently qualifies, its price is up more than 40% from the purchase price, or there is no qualifying stock to replace it. If a stock has been held for over four years, it needs to be up 10% per year held to avoid being sold (for example, a stock held six years needs to be up 60%). Time and return are based on the initial purchase for the portfolio.

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 10 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.
  • 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, shares 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 available new purchases, the excess receipts are kept in cash until the next review. If too much cash is accumulated, the rules will be adjusted.
  • 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.

Discussion

Richard Gerspacher from FL posted over 8 years ago:

Does anyone know why AUTO can not be purchased anymore? I have spoken to both Etrade and USAA Brokerage and both will NOT disclose why they will not allow purchase of this security. Thank you.


max mccormcik from az posted over 8 years ago:

As a new member of AAII, I need to ask which discount brokerage has the most timely results on executing orders? Which brokerage offers the best return for the cost of executing orders? As AAII wants our costs to be as low as possible, why does AAII recommend using mutual funds as opposed to EFT's? I am presently looking to start a portfolio of stocks consisting of the following 10 stocks. ACET, ANFI, DLA, ZEUS, SENEA, STRT, TCS, SGMA, AUTO and TSQ. Any suggestion as to the choice and advisability of these 10 selections will be appreciated.


Stu Cullen from Florida posted over 8 years ago:

Should I assume that any stock in the "Shadow Portfolio" will meet all the criteria of the above "Model Shadow Stock Portfolio Rules"? And when the stock no longer meets all the Rules you will email or publish on your site that you no longer recommend holding said stock ? (I'm a "Newbie" please bear with me.)


Charles Rotblut from IL posted over 8 years ago:

Max, We'll have an updated review of online, discount brokerage firms later this year. The results from our 2017 brokerage survey are available right now, however. As far as mutual funds, we don't recommend them over ETFs. Consider both types of funds and pick the best one based on your needs. -Charles


Charles Rotblut from IL posted over 8 years ago:

Stu, The Shadow Stock Portfolio holds stocks until they violate a sell rule. We don't sell a stock just because it no longer meets the buy criteria to reduce turnover, which hurts returns. Stocks held in the portfolio and continuing to meet the buy criteria are designated as "qualifying." -Charles


N. Levings from MI posted over 8 years ago:

Any possibility of creating mutual fund of the Model Stock Portfolio ?


Wayne Thorp from IL posted over 8 years ago:

@N. Levings, As a nonprofit, AAII cannot manage money. Furthermore, the companies that make up the Shadow Stock portfolio are exactly the stocks that cannot be bought by a mutual fund or other professional money managers because of their small size and relative illiquidity, which makes them perfectly suited for individual investors. Wayne A. Thorp, CFA Senior Financial Analyst, AAII


Dave Gilmer from WA posted over 8 years ago:

I continue to be disappointed by the recent 1 year and 3 year performance of this portfolio. When I read this comment in the article: "Keep in mind that research continually shows that, among individuals and professional investors alike, those with a consistent approach win and those who keep changing strategies lose." - I wondered how consistent the approach has been in recent years in the name of trying to improve performance. To that end I went back to my April 2011 issue and looked at those Portfolio Rules and highlighted everything in this most recent issue that wasn't there. The amount of "highlighter" in this issue was sorprising to me.


Jyotir Jani from GA posted over 8 years ago:

I am concerned about significant decline in the share price of Aceto Corporation and AUTO shares. Any guidance regarding these two particular investments in the model stock portfolio. Are they still in a BUY range? Do you recommend buying more shares of these two stocks as the loss has been significant. The future prospects for ACET specifically is concerning, unsure if value is there unless there is a potential buyout but they have a lot of debt.


Bob Gilstein from MA posted over 7 years ago:

A review of the buys & sells of the current 30 shadow stocks reveals poor to horrible performance since the buys, and sells that occurred well after the stocks had crashed. Only 5 of the 30 could be considered well done. I find your performance claims very hard to believe. And I will certainly never use your buy/sell recommendations.


John Izydorczyk from FL posted over 7 years ago:

The Shadow Stock Portfolio has become a joke, right? AAII is so ashamed of its performance that it is now listing just the holdings and not the quantities. A portfolio list is not a portfolio unless it reveals the quantity held. For those who may care, as of today (14 Jun '19) the YTD performance is 2.49% (worse than any index you may compare it to) and the return since inception in 2003 is 12.78% - no better than most mutual funds. Reason why the SSP has had such poor performance since 2014, easy, "Failure to sell stocks with negative earnings.". During the years 2017 and 2018, stock after stock in the SSP had negative PE ratios yet these stocks remained in the portfolio. I could name them, but what is the use?


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