The Model Shadow Stock Portfolio’s Long-Term Performance

The Model Shadow Stock Portfolio is down 9.3% year-to-date as compared to –3.0% for the S&P 500 index, as represented by the Vanguard 500 Index fund (VFINX).

The retreat by the model portfolio reflects not only the weakness in the overall market, but also the current weakness in value and small stocks. Longer-term results can be seen in Figure 1 and Table 3.

While this year is not yet over and a rebound is very possible, the Model Shadow Stock Portfolio could trail the overall market for the second year in a row. This happened twice before—in 1998–1999 and 2007–2008, as you can see in Table 3. So far, the portfolio has never underperformed three years in a row, although it has been down or even for three consecutive years (1998–2000).

Adjusting the Cumulative Return Chart

I am frequently asked, in reference to the cumulative return chart in Figure 1, why the Model Shadow Stock Portfolio seems to have outperformed its benchmarks by such a wide margin in recent years. The explanation is that any series of returns over the long term will result in an upward curve due to the compounding of the returns; it’s the so-called magic of compounding. Some of you have suggested we should go to a logarithmic representation, where equal percentage moves appear equal, since the model portfolio return line is getting rather extreme on the chart.

We show both forms in Figure 1 here so you can see the difference, but we will only show the log chart in the future for cumulative return.

Portfolio Changes

There are no portfolio changes this quarter because we did not have a sell required for reasons either good (surpassing the value limit or size limit) or bad (violating earnings probation). The current portfolio can be seen in Table 1.

However, we had more stocks qualifying for purchase than we have seen in a long time. Even with my liquidity requirement added to the usual rules, there were 23 qualifying stocks. Five of these were either Chinese or already in the portfolio, but that still left 18 companies that met the initial purchase criteria. (At this point, we do not add any new stocks to the portfolio unless a stock is removed, freeing up funds.)

In the past, the expansion of qualifying stocks has gone hand in hand with a weaker market, and the eventual reduction in qualifying stocks after a maximum indicates an up market. However, our evaluation of this behavior as a possible early indicator of a market change proved that it was a lagging indicator and not a useful predictor.

Looking Ahead

The market keeps reacting to possible dates when the Federal Reserve may initiate a gradual raising of interest rates. In a sense, the reaction seems foolish. When we have good news about the economy, the stock market goes down because that means the Fed will stop supporting the market with low rates. It’s kind of like wanting to stay sick so the doctor won’t take away your medicine.

Eventually the market will forget the Fed and concentrate on the economy and particularly company earnings. I remember when the important thing to watch was the various measures of money supply, and the market would dance to that music. In any event, how much impact on rates can the Fed have if everyone in the world wants their money in U.S. Treasuries?

While I have given up on 2015 being super bullish because of the pre-election year boost and the year ending in “5” phenomenon, I still have a bullish bias.

Figure 1. Model Shadow Stock Portfolio vs. Benchmarks (Through 8/31/2015)

We will discuss the Model Shadow Stock Portfolio again in the January 2016 AAII Journal. In the meantime, you can follow it in the Model Portfolios area 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 or equal to 1.00. (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 and, if there are earnings estimates, the estimates must be positive for the current quarter and year.
• 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. 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.

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.
• 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.

Table 2. Third-Quarter 2015 Transactions

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 1.00.
• At the end of a quarter, if receipts from stock sales are insufficient to buy all newly qualifying stocks, purchases are made based on the width of the bid-ask spread and the number of shares at bid or ask price.
• 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.

Table 3. Model Shadow Stock Portfolio: Annual Performance