Model Shadow Stock Portfolio: Purchase Guidelines and Rule Changes

The Model Shadow Stock Portfolio is up 55.6% year-to-date compared to 29.0% for the S&P 500 index, as measured by the Vanguard 500 Index fund (VFINX). Figure 1 shows the year-to-date returns as of November 30, 2013, as well as annual returns for one-, three- and 10-year periods.

This has been an exceptional year, and if the Model Shadow Stock Portfolio stays at this level it will be the third-best year in its 21-year history. As you can see in Table 3, the years 2003 and 2009 were both up over 70%.

Many pundits keep predicting a pullback. It may happen, but the market increase has about doubled since the dire predictions began.

We had been running a chart in this column showing the number of first-pass qualifying stocks at my quarterly review. If the number of stocks passing my initial screen each quarter had any predictive value, the market would have fallen six months ago, since very few stocks have been qualifying. Like most possible predictors of future market direction, it has not shown any meaningful guidance. Therefore, we are no longer showing historical figures here in chart form, although we may mention the number of qualifiers when discussing purchases.

Unusual Activity

There have been only a couple of times in 20 years where dramatic news came out right after a stock was purchased for the portfolio and before the purchase was reported to you. This time, it was Fab Universal Corp. (FU). The situation with Fab Universal involved a report of unexpected high earnings for the quarter with very positive predictions for the future. This drove the stock price up dramatically from $4.25 to an intraday high of $11.25. Shortly afterward, short sellers challenged the figures, emphasized the extreme dilution coming, and questioned the validity of the sales. (You can go online to SeekingAlpha.com for the details.) The stock price had dropped to $5.50 by the time we sent out an emergency notice to sell on November 20, and a few days later it stopped trading.

Figure 1. Model Shadow Stock Portfolio vs. Benchmark (Through 11/30/2013)

 

By the time we indicated our purchase, the stock had increased so much that its price-to-book-value ratio was far above 0.80; based on our rules, it should not have been purchased. If you purchased it on the way down when it qualified again (based on questionable data), I hope our emergency sell message got to you. If it did not, I would recommend selling it when you can, as we did in the actual portfolio.

The story of Fab Universal does present an opportunity to review two guidelines.

First, when we announce a purchase, enough AAII members may try to buy the stock that it moves the price up. This tends to even out and a little patience is usually rewarded. But as pointed out in the portfolio rules, you should not buy the stock if the price-to-book-value ratio goes higher than 0.80 (if there is a shortage of eligible stocks or you already have some of the stock, it is acceptable buy at a price-to-book-value ratio as high as 0.90). You can check the current price-to-book-value ratio in the Actual Portfolio table at the Model Shadow Stock Portfolio page on AAII.com, where the figures are updated in real time (go to www.aaii.com/model-portfolios/portfolio).

Second, you should also check the news about the stock to make sure a negative earnings or other disqualifying report did not come out between our purchase date and the date when you are buying. Yahoo! Finance (finance.yahoo.com) or your broker’s website will list such news items. News can push the stock price up or down. If the stock is violating one of the buy rules, do not buy it. If it is not clear what the impact of the news item (tender offer, class-action lawsuit, etc.) will be, avoid the stock. Bad things will occasionally happen, but they tend to be offset by unexpected good things and a diversified portfolio reduces shocks significantly.

Rule Change

Due to the impact that the bull market is having on the overall market capitalization of stocks, we are increasing the maximum market cap buy criterion to $300 million.

This raises our selling point to $900 million (three times the initial maximum) and our warning level to $750 million (two and a half times the initial maximum).

Portfolio Changes

Table 1 shows the current holdings in the Model Stock Portfolio.

We sold Fab Universal on an emergency basis due to uncertainty about the validity of their data. In the past, we have eliminated Chinese stocks; in the future, we will eliminate U.S.-based companies whose main business is in China as well.

We also sold Addus Homecare Corp. (ADUS) because it went over the price-to-book limit of 2.40 (three times the initial criterion of 0.80) and is no longer a value stock.

We bought Five Star Quality Care Inc. (FVE) and added to our holding of LMI Aerospace Inc. (LMIA), which still qualified, because we had excess funds and did not have enough cash to buy a full position in September when it was initially added to the portfolio.

Because of the increase in the permissible market cap to $300 million, (raising the sell requirement to $900 million), we did not have to sell Standard Motor Products (SMP) this month.

Changes are summarized in Table 2.

Looking Ahead

As of this writing, we now know President Obama’s choice for Federal Reserve chairman, and the first reduction in quantitative easing (the Fed’s bond-buying program) was announced just before we went to press. Many gurus believe the stock market will weaken with the tapering of quantitative easing because of investors switching from stocks to bonds. Given that continued tapering will depend on a strengthening economy, any hit to the stock market should be short-lived, particularly if earnings continue to be strong.

The election cycle indicator has been so far off the mark lately that I hesitate to even mention it, but the second year in the cycle (2014) has historically been slightly below the overall average at 11.5%. However, 2013 would have been up only 6.7% based on the first-year election cycle average since 1935, so I wouldn’t take the cycle indicator too seriously.

The next column on the Model Shadow Stock Portfolio will be in the April AAII Journal. In the meantime, you can follow updates at AAII.com and through the AAII Model Portfolios Update email (sign up at www.aaii.com/email).

Happy New Year!