Model Shadow Stock Portfolio: Why Quarterly Reviews Still Make Sense

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.