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AAII Model Portfolios Small Cap Value Investing

Model Shadow Stock Portfolio Rules Amended and Clarified

The valuation and market capitalization sell rules have been amended. Plus, the maximum price to pay for new stocks is now listed.

by James B. Cloonan | April 2014

Featured Tickers:

The strong five-year bull market continued in December, slowed in January for some profit realization, and tried to continue in February.

 

January represented quite a pullback for the Model Shadow Stock Portfolio. The year-to-date return through February is –3.6% as opposed to +0.9% for the S&P 500 index, as measured by the Vanguard 500 Index fund (VFINX). As I write this in early March, small stocks have strengthened again. Returns for longer periods can be seen in Figure 1 and Table 3.

Figure 1. Model Shadow Stock Portfolio vs. Benchmark (Through 2/28/2014)

Figure 1. Model Shadow Stock Portfolio vs. Benchmark (Through 2/28/2014)
 

This has been a very long bull market without any significant correction, although most pundits have been predicting one for over a year. The market is still behind where it would have been if it had risen by its average of 12% a year from 2006 and avoided the great recession. Undoubtedly there will be a correction sometime, but it could be in two weeks or two years.

Table 1. The Model Shadow Stock Portfolio

  Current 52-Week Market P/E P/B Div  
  Price High Low Cap Ratio Ratio Yield  
Company (Ticker) ($) ($) ($) ($ Mil) (X) (X) (%) Notes
Alamo Group, Inc. (ALG)
52.58
61.27
35.34
635.2
18.7
1.87
0.5
 approaching size limit
Alpha & Omega Semicon (AOSL)
7.29
9.30
6.64
189.5
nmf
0.66
0.0
 earnings probation (2013 Q4)
CSS Industries Inc (CSS)
27
31.94
21.57
251.0
13.9
0.97
2.2
  
Ducommun Incorporated (DCO)
27.8
31.35
14.32
301.3
17.3
1.24
0.0
  
Ennis, Inc. (EBF)
15.8
19.59
13.54
414.4
11.9
1.09
4.4
  
Five Star Quality Care (FVE)
5.79
6.87
4.41
281.5
25.2
0.90
0.0
  
Flexsteel Industries (FLXS)
37.15
37.80
18.56
268.3
22.4
1.72
1.6
  
Hardinge Inc. (HDNG)
14.75
16.88
11.91
175.3
41.0
0.88
0.5
  
Hooker Furniture Corp. (HOFT)
15.1
18.31
13.35
162.4
17.0
1.21
2.6
  
International Shipholding (ISH)
30.46
32.12
16.07
220.8
14.9
0.66
3.3
 qualified as of 2/28/2014
Key Tronic Corp. (KTCC)
10.35
12.19
9.60
109.0
11.3
1.09
0.0
  
Kimball International (KBALB)
18.77
19.86
8.63
571.4
24.7
1.70
1.1
  
LMI Aerospace, Inc. (LMIA)
14.91
22.69
10.81
191.7
19.9
0.89
0.0
  
Marlin Business Services (MRLN)
21.5
29.58
17.32
279.4
16.8
1.65
2.0
  
Medical Action Industries (MDCI)
7.32
10.07
5.04
120.0
30.5
1.21
0.0
  
Mitcham Industries (MIND)
14.39
18.41
13.58
184.2
30.6
1.06
0.0
  
Olympic Steel, Inc. (ZEUS)
27.51
31.68
19.54
301.7
nmf
1.01
0.3
  
PC Connection, Inc. (PCCC)
20.25
25.94
13.83
530.5
15.0
1.66
0.0
  
PCM Inc. (PCMI)
9.71
11.96
6.02
113.7
13.5
0.91
0.0
  
RCM Technologies (RCMT)
6.91
7.22
5.29
86.0
18.7
1.36
0.0
  
Renewable Energy Group (REGI)
11.67
16.50
5.90
451.4
2.9
0.71
0.0
  
REX American Resources (REX)
47.68
49.93
17.12
385.1
28.9
1.47
0.0
  
Rocky Brands Inc. (RCKY)
13.76
19.97
13.13
103.4
14.0
0.79
2.9
 qualified as of 2/28/2014
SigmaTron International (SGMA)*
10.71
10.80
3.77
42.4
23.3
0.79
0.0
 qualified as of 2/28/2014
Salem Communications (SALM)
9.09
10.14
6.17
226.5
nmf
1.15
2.4
 earnings probation (2013 Q1)
Shoe Carnival, Inc. (SCVL)
25.84
29.75
19.19
529.5
17.9
1.63
0.9
  
Standard Motor Products (SMP)
35.15
39.99
24.52
806.9
15.4
2.32
1.5
 approaching size & value limits
TravelCenters of America (TA)
9.06
12.50
6.71
340.9
15.6
0.67
0.0
  
VOXX International (VOXX)
13
18.00
8.91
316.9
9.6
0.66
0.0
  
Willis Lease Finance (WLFC)
17.9
18.24
11.70
150.9
17.9
0.72
0.0
  
*Company is new to the portfolio as of 3/3/2014.
nmf = no meaningful figure.
Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 2/28/2014.

Explanation of 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 $300 million. Stocks are marked “approaching size limit” if their current market cap exceeds 2½ times the initial criterion, or $750 million. 
 
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 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 in parentheses is 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.

Rules Clarification

Our general rules for the Model Shadow Stock Portfolio permit foreign stocks if they are listed on a U.S. exchange. Our (possibly) temporary rule against companies located in China or doing most of their business in China is not included in the general screening criteria, nor is our elimination of stocks not trading an average of $150,000 in volume per day included. These screens must be performed manually if you choose to use them or a variation of them.

We are also amending the rules for selling stocks based on high price-to-book ratio or market capitalization. We will not sell based on these criteria unless we have a stock to buy. This has never been a problem over the last 20 years, but it has recently become a concern.

New Data on Purchase Price

The world can change between the time we purchase a stock and the time you find out about it. You should check recent news on the company to make sure nothing has happened that would disqualify it.

Table 2. Fourth-Quarter 2014 Transactions

Buy  
Company (Ticker) Maximum Price to Pay
SigmaTron International (SGMA) $12.20
   
Sell  
Company (Ticker) Reason for Selling
Gilat Satellite Networks Ltd. (GILT) negative earnings

You should also never pay a price-to-book ratio over 0.90. While 0.80 is our normal criterion, going as high as 0.90 is acceptable. To help with this, we will now indicate in Table 2 the maximum price to be paid for new additions to the portfolio.

Portfolio Changes

Table 1 shows the current holdings in the Model Shadow Stock Portfolio. We sold Gilat Satellite Networks (GILT) because it violated probation.

After eliminating Chinese stocks and those we already owned, there was only one qualifying stock, SigmaTron Int’l (SGMA), and we bought it. As Table 2 indicates, the maximum price to pay for SGMA would be $12.20 per share, based on the company’s current book value of $13.56 multiplied by our maximum price-to-book criterion of 0.90.

Looking Ahead

Almost all the economic data indicates a slow and steady recovery. The extreme winter weather had an effect, but everyone seems to be allowing for that. The only negative I see is the fact that things look too good, and as a moderate contrarian this always worries me a bit. Of course, as always, there are international concerns, and we have a mid-term election coming up that will probably stir up real and imagined concerns.

Table 3. Model Shadow Stock Portfolio: Annual Performance

  Average Annual Return (%)   Cumulative Value of $10,000 ($)
  Model Vanguard Vanguard   Model Vanguard Vanguard
  Shadow 500 Small Cap   Shadow 500 Small Cap
  Stock  Index Index   Stock  Index Index
Year Portfolio (VFINX) (NAESX)   Portfolio (VFINX) (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
YTD -3.6 0.9 2.9   328,176 63,596 85,359
Since Incep 17.9 9.1 10.7   328,176 63,596 85,359
Data as of 2/28/2014.

I have always felt that the majority of pundits will be wrong when predicting markets. Last year was a perfect example: There were a significant number of experts predicting a strong down year, a modest down year or a moderate up year. Virtually no one was predicting a strong up year, and that is what we got.

This year, we have many predictions for a significant correction and for a modest up year. That leaves a modest down year or another strong up year as likely outcomes. As always, only time will tell.

We will be covering the Model Shadow Stock Portfolio again in the July AAII Journal. In the meantime, you will be able to follow it at AAII.com.

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. If the price-to-book-value ratio moved up a bit since the stock was included in the portfolio, it is still OK to purchase the stock unless this ratio goes above 0.90. (Figure will change gradually with changes in overall market values.)
  • Market capitalization must be between $30 million and $300 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 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. 
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.

Discussion

Paul Franklin from NJ posted over 12 years ago:

In the transaction history, a 6 or 7 stocks were sold in 2007/2008 with the reason "2 year rule." The current "2 year rule" is a reason to avoid purchasing a stock. Was there a prior limit on the time a stock was held, or have I misunderstood the documentation?


Jeff Goodwin from CA posted over 12 years ago:

An old adage in the market is "cut your losses and let you profits run." Might there be a way to add a rule such as buy a put option on an issue when it reaches what you believe to be full value? Would beat kicking yourself for selling and then watching it continue on up or worse, watching it get taken out. Options are wasting assets but they have their uses - like car insurance on your BMW. Just thinking out loud...


Charles Rotblut from IL posted over 12 years ago:

Jeff, Due to the small capitalization size of the companies held in the Shadow Stock portfolio, options are not always available. -Charles


Brad Schulz from MI posted over 12 years ago:

What secondary screenings do you use when there are more opportunities than funds available? Or rather, how do selectively rank stocks that pass the Shadow Stock Screen?


Terrence Lindemer from TN posted over 12 years ago:

Generally, I find the AAII portfolios and tabular data very useful. I've been in the market since 1965. But in my humble opinion your percentage gain charts for all your model portfolios are impossible to compare with the usual log (price) vs time charts generally available with mutual funds, and with Stockcharts.com, both of which include reinvestment of distributions. The slope of the log-vs-time chart is also a direct function of annual return. What are the chances of AAII converting its charts to something, if I may say so, actually useful? Thanks and my appreciation in general.


Jeff Goodwin from CA posted over 12 years ago:

Charles- Used to be you could go to an option dealer - I worked a trading desk where we had a partner that would write any option you wanted - and he didn't use Black Scholes. But that was then. Still a good tool... jg


Jean Henrich from IL posted over 12 years ago:

From Jim Cloonan's Commentary on the portfolio in January 2008: "As you will see in viewing the portfolio's activity this period (shown at the Transaction History link), there is suddenly an abundance of new qualifying stocks--so much so that we reduced the price-to-book ratio criterion back to 0.80, and we had to sell most of our two-year rule stocks (in which the stock has not met the buy criteria for over two years) to obtain funds to buy the new opportunities." And from his April 2008 Commentary: "We continue to find new qualifying stocks and have sold McRae Industries (MRINA), the last of our two-year-rule stocks (the stock has not met the buy criteria for over two years), to free up funds for new purchases." The Commentaries are posted in a box below the Transaction History link at the Model Shadow Stock Portfolio page. -Jean, AAII


C Rayner from CA posted over 12 years ago:

Clarification of sell criteria. I sold PCCC too early because I interpreted the word "initial" as referring to the "buy" criteria at the time the holding was purchased. I suggest you consider changing the word "initial" to the word "buy"


William Yon from AL posted over 12 years ago:

I have not been able to sell FU (Fab Universal)since your "emergency sell" recommendation. How about some updates on what's going on with FU.


Charles Rotblut from IL posted over 12 years ago:

Hi William, Unfortunately, there are no updates we can give regarding the stock. Until the exchange either allows trading to resume or the stock loses its listing, shares are likely going to remain in their current limbo. -Charles


Charles Rotblut from IL posted over 12 years ago:

Brad, Here is what Jim said regarding secondary screenings: I use the lowest price/book ratio, but if the ratio is within .15 (i.e. .60 vs .46 ), I consider them equal and use the smallest bid/ask spread %. -Charles


Charles Rotblut from IL posted over 12 years ago:

Fab Universal update: The company has issued a press release saying it had until April 17, 2014, to file a plan of compliance with the New York Stock Exchange. If the plan, as submitted, is not accepted, the company's stock will be subject to delisting proceedings.


Jim Mckercher from OR posted over 12 years ago:

What is your take on " Go Away in May" as it pertains to Shadow stocks?


Russell Abbott from CA posted over 12 years ago:

Would you explain how you decide how much money is available to buy a stock. The portfolio never shows a cash balance. Does that mean the portfolio is always fully invested, even if that requires buying one or two shares of the latest purchase? Also, if you sell a stock and have nothing new to buy, what happens to the money? Are small lots of shares currently owned purchased to use those funds? Thanks.


Charles Rotblut from IL posted over 12 years ago:

Jim, Part of the Shadow Stock Portfolio's strategy is to limit transaction costs. Hence, practices that result in selling more frequently, such as technical analysis and buying/selling on a seasonal basis are avoided. Keep in mind that even during the "worst six months," large-cap stocks often end October with higher prices than they traded at in May. -Charles


Mary Quigley from IL posted over 12 years ago:

What is your view on Jazz? I purchased this stock when it was $171.31 and since then it has gone down to $131.31. There has not been any news about this stock and I would like to know if I should sell or hold? Mary Quigley


John from Georgia posted over 12 years ago:

What is the reasoning behind the $4 minimum rule to purchase Shadow Stocks? Thanks, John


Charles Rotblut from IL posted over 12 years ago:

Russell, Per Jim Cloonan, up to 5% of portfolio is kept in in cash if there aren't qualifying new purchases. If there is more than 5% of cash free, reinvestments are made into some of the old holdings that still qualify. We don't buy very small quantities where the commissions would be high as a percentage of purchase, however. -Charles


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