It is always satisfying to see your holdings zoom off at a torrid pace, wheels screeching and competitors in the dust.

The only problem, however, comes down the road, when the portfolio inevitably runs out of gas.

I warned about this in my review of the Model Shadow Stock Portfolio in the April 2005 AAII Journal [posted as Commentary at the Shadow Stock Portfolio page of AAII.com]. At that time, it had clocked a 33% return over the prior six-month period.

Well, we are now six months down the road. And sure enough, the Model Shadow Stock Portfolio is starting to run on fumes alone. During the last three months (through the end of May), the portfolio ran in reverse—it was down over 6.5%. However, calendar-year 2005 to date, it is down 1.1%.

Figure 1. Model Shadow Stock Portfolio vs. Benchmarks (Through 5/31/05) CLICK ON IMAGE TO SEE FULL SIZE.

Fortunately for the Model Shadow Stock Portfolio, it is a market-wide gas shortage. The Model Stock Portfolio’s year-to-date figure is just about dead even with the S&P 500’s year-to-date figure of –1.0%, and better than the –2.5% for small-cap stocks.

The returns for various periods can be seen in Figure 1. It certainly helps to have a head start.

The year through May has been an up-and-down-sideways affair and not the strong up year that historically occurs in years ending in 5. However, the year is not over and there are some signs of market strength. But uncertainty about the economy, interest rates, and oil prices will continue to make the market volatile.

Portfolio Activity

Table 1 shows the current list of stocks in the Model Shadow Stock Portfolio.

There was activity in the portfolio in May, with four sales and three additions, as highlighted in Table 2.

Several of the trades had unusual aspects which are worth noting.

Dura Automotive Systems (DRRA)
Dura Automotive was sold without ever having been on probation. This resulted from a restatement of earnings, which created both a down year and a following down quarter all at once. Those of you who update your portfolio more often than once a quarter may have dumped DRRA even earlier.

Finlay Enterprises (FNLY) and GenTek (GETI)
Two of our buys—Finlay Enterprises Inc. and GenTek Inc.—came out with negative quarterly earnings shortly after we bought them. GenTek immediately went down.

Finlay Enterprises is particularly interesting because it makes a profit every year, but all of it is in the fourth (holiday) quarter. Under our Model Stock Portfolio rules, it would only qualify after the fourth-quarter earnings report and before the first-quarter earnings report each year. Since neither of these two stocks would qualify under the rules if they were being screened right now, I will leave it up to you whether to buy them or not.

I would suggest buying Finlay Enterprises anyway because it meets the spirit of our approach, even if the nature of its business only qualifies it after fourth-quarter earnings.

Metals USA (MUSA)
We also have a buyout pending. Metals USA, which was approaching our size limit, is being bought out by Apollo Management for $22.00 a share. Since the Model Shadow Stock Portfolio is still holding the stock, I thought this would be a good time to look at the question of what to do with a tender offer that has been approved by the board of the target company.

The Model Shadow Stock Portfolio rules say that in this situation, you should use your best judgment. My own usual approach is to sell the stock at the next quarterly portfolio adjustment. However, if—as in this case—I do not have another stock on my buy list, I will wait for the actual buyout and pick up the current discount from the buyout price, which is almost always higher than the interest rate from a stock broker.

The Two-Year Rule

We are providing the Model Shadow Stock Portfolio rules again this issue (Table 3), and I want to emphasize the meaning of our two-year rule (which appears under the “Stocks are sold” section of the Purchase and Sales Rules).

If we have held a stock two years and it no longer qualifies, we will sell it in order to buy a stock that does qualify—if there is one. The stock we sell may be a perfectly good stock and may have a profit, but we believe that a newly qualifying stock has a better chance for appreciation. This rule is meant only for portfolios in which you do not want to expand the number of holdings—in other words, where you can only buy a stock if you sell a stock to free up cash for the purchase.

For those who are adding cash to the portfolio, there is no need to sell stocks after two years as long as you have funds for the new purchases. Our actual portfolio is limited to the funds in it, so we must sell to buy. When the time comes, we will indicate any sells that are driven by the two-year rule.

Finding Qualifiers

I have had several inquiries indicating difficulty in finding qualifying stocks.

We are looking for very special stocks and it will require a bit of patience to build a portfolio. You may want to stretch the criteria a little, which is fine. If the market starts to rise, we may have to adjust the official criteria.

If it is the bid/ask spread rule that is creating problems for you, try placing limit orders in between the bid and ask, and be willing to build the desired position in stages.

Monthly Updates at AAII.com

I will be reviewing the portfolio here in the AAII Journal in another three months. However, information on this portfolio is updated monthly at our Web site: www.aaii.com.

This year has been rather unusual in terms of the timing of the ups and downs. Perhaps the summer, which is usually lackluster, will also surprise us.

James B. Cloonan is founder and chairman of AAII.