December 2018 Model Shadow Stock Portfolio Update

The Model Shadow Stock Portfolio was down 2.9% during November, pushing its cumulative decline into bear market territory. Over the last three months the Model Shadow Stock Portfolio has declined 20.5%, marking the fifth time it has been down 20% or more over its nearly 26-year existence. In contrast, the S&P 500 index as measured through the Vanguard S&P 500 Index fund (VFINX) has had only two observed bear market periods over the same time frame, but they were much longer on average.

We examined the monthly total returns of the Model Shadow Stock Portfolio along with the VFINX to gain a sense of the frequency, duration and severity of corrections and bear markets.

The Model Shadow Stock Portfolio has a cumulative total return of 3,304.7% over its history, compared to the 933.8% cumulative total return of the VFINX. The greater long-term observed return however has come with greater short-term volatility. On average, the Model Shadow Stock Portfolio has been up 62.7% of individual months during its existence. This means of course that it has had negative months 37.3% of the time. In contrast the VFINX has had positive monthly returns 66.2% of the time, or down months 33.8% of the time over the same time period.

Corrections are generally classified as declines of 10% or greater. The Model Shadow Stock Portfolio has had 10 observed corrections and five of them have gone on to become bear market corrections of 20% or greater. The average correction has been 1.3 years in length, with an average drawdown of 21.5%. The drawdown is the maximum loss sustained during a given downturn. The duration is the time it takes the portfolio to return to its level just before the downturn began. The longest correction (July 2007 to November 2010) was 3.4 years and had a drawdown of 63.4%.

The Vanguard S&P 500 Index fund has had three observed corrections and two of them have gone on to become bear market corrections of 20% or greater over the same time period. The average correction has been 3.8 years in length with an average drawdown of 37.1%. The longest correction (September 2000 to October 2006) was 6.2 years with a drawdown of 44.8%, but the largest drawdown of 51.4% was with the 2007 bear market that lasted 4.8 years (November 2007 to July 2012).

As shown in the table below, the Model Shadow Stock Portfolio has more frequent corrections and bear market cycles than the S&P 500, but the down markets have generally been shorter in duration and bull markets stronger.

If you are tempted to time the market, we suggest that you reread our May 2018 Model Portfolios article titled “Model Shadow Stock Portfolio: Staying Invested All 12 Months.” The article examines the impact on your returns if you should happen to miss just one month during the year in the which the market has its best return.

AAII Model Shadow Stock Portfolio Changes

After conducting the quarterly review of the Model Shadow Stock Portfolio, two stocks are being removed from the tracking portfolio. With the cash on hand and the proceeds from the two sells, there was enough to purchase one new stock with a position size roughly equal to the average position size for the portfolio holdings.

Sell Alert: AutoWeb Inc. (AUTO)

AutoWeb Inc. was on earnings probation since it announced its second-quarter 2018 earnings on August 2, 2018. With the second-quarter results, the company’s trailing 12-month adjusted earnings fell to a loss of $0.10 per share, placing it on earnings probation. The company announced a third-quarter loss of $0.19 per share on November 8. If a Shadow Stock that is on earnings probation reports a subsequent quarterly loss, it is removed from the portfolio.

Sell Alert: SigmaTron International (SGMA)

SigmaTron International was on earnings probation since it announced its fourth-quarter 2018 earnings on July 20. With the fourth-quarter results, the company’s trailing 12-month adjusted earnings fell to a loss of $0.64 per share, placing it on earnings probation. The company announced a first-quarter 2019 loss of $0.85 per share on September 12. If a Shadow Stock that is on earnings probation reports a subsequent quarterly loss, it is removed from the portfolio.

Buy Alert: VSE Corp. (VSEC)

The portfolio management rules of the Model Shadow Stock Portfolio encourage investing in positions roughly equal to the average position size of the portfolio. Doing so avoids investing in overweighted or underweighted positions, thereby diminishing the diversification impact of a given stock. The underweighted position sizes of AutoWeb and SigmaTron, as well as the cash in the portfolio, only generated enough proceeds to buy one new position. The new addition is:

• VSE Corp. (VSEC): November 30 closing price of $29.13; tracking portfolio purchase price of $29.55 on December 4

Based on VSE Corp.’s closing price of $29.13 on November 30, we suggest paying no more than $32.37, which provides a 10% cushion given that its price-to-book-value ratio was very close to the 1.0 cutoff for the Model Shadow Stock Portfolio. To calculate the maximum buy price based on the price-to-book-value ratio, multiply the current share price by the ratio of the maximum price-to-book ratio to be considered for the Model Shadow Stock Portfolio (currently 1.0) to the current price-to-book ratio of the stock. The price-to-book ratio for VSE as of November 30 was 0.99, so the calculation, including the 10% cushion, is: [$29.13 × (1.0 ÷ 0.99)] × 1.1 = $29.13 × 1.01 × 1.1 = $32.37.

Model Shadow Stock Portfolio Notes and News

We continue to see a good number of small-cap value stocks passing the Shadow Stock screen. As of the end of November, 25 stocks met the initial selection criteria for the Model Shadow Stock Portfolio, slightly down from 26 one month ago. Of the 25 stocks passing at the end of November, 10 are currently held in the Model Shadow Stock tracking portfolio (up from eight the month prior): Beazer Homes USA Inc. (BZH), CPI Aerostructures Inc. (CVU), Delta Apparel Inc. (DLA), Flexsteel Industries Inc. (FLXS), Hallador Energy Co. (HNRG), New Home Company Inc. (NWHM), Olympic Steel Inc. (ZEUS), Strattec Security Corp. (STRT), Universal Stainless & Alloy Products (USAP) and VSE Corp. (VSEC). Companies held in the Model Shadow Stock Portfolio that currently meet the initial purchase rules are designated as “currently qualifies” in the notes column of the Model Shadow Stock Portfolio table on AAII.com. However, the notes may not match the list here since the passing list on the website is revised daily and the notes are dynamically updated based on the revised list.

As of the end of November, RCM Technologies Inc. (RCMT) and Vishay Precision Group Inc. (VPG) still have the highest price-to-book values. RCM Technologies has seen its price-to-book-value ratio decline from 2.18 to 1.96, while Vishay Precision Group’s ratio has increased from 2.12 to 2.13. Shadow Stocks with a price-to-book-value ratio above 3.00 at the time of a quarterly review are sold from the model portfolio, assuming there is a suitable replacement.

Currently, Renewable Energy Group is approaching the market-cap cutoff of $1.2 billion (three times the initial limit for consideration of $400 million) with a market cap of $1.026 billion at the end of the month.

Beazer Homes had the strongest monthly price gain in the Model Shadow Stock Portfolio with its 27.8% gain during November. Amira Nature Foods Ltd. (ANFI) was the weakest holding with its monthly price decline of 24.7% during November.

Click here to see the current purchase and sell rules for the portfolio. The size and value rules are subject to revision depending on prevailing market conditions.

The next quarterly review of the Model Shadow Stock Portfolio will take place at the end of February 2019. Any changes to the portfolio will be announced at the time they are made in a special Model Portfolios Update email (sign up at www.aaii.com/email).

Here are some news highlights for the current holdings in the AAII Model Shadow Stock Portfolio:

• Aceto Corporation (ACET) reported financial results for fiscal-2019 first quarter ended September 30, 2018. The company reported net sales of $164.4 million, a decrease of 11.3%, compared to $185.3 million in the prior-year quarter. Gross profit was $25.5 million, a decrease compared to $40 million in the prior-year quarter, reflecting lower gross profit in the human health segment partially offset by gains in the pharmaceutical ingredients and performance chemicals segments. Gross margin for the quarter was 15.5%, compared to 21.6% in the prior-year quarter. Total selling, general and administrative expenses (SG&A) were $36.9 million, an increase of 18.5% over the same period last year. The company reported an operating loss of $13.3 million, compared to an operating income of $7.2 million in the prior year’s quarter. Net loss per share was $0.59 per share, compared to net income of $0.1 per share in the same period last year.
• Beazer Homes USA Inc. (BZH) reported financial results for the quarter and fiscal year ended September 30, 2018. For the fourth quarter, the company reported homebuilding revenue of $761.5 million, up 14.4% year over year. Net income from continuing operations was $60.5 million, up 79.5% year over year. Net income per share was $1.15 per share, compared to the I/B/E/S consensus estimate of $1.07 per share, beating the analyst estimate by 14.2%. For the fiscal year, the company reported net income from continuing operations of $63.8 million, excluding impairments, abandonments, debt extinguishment costs and the impacts from federal tax reform and the change in the deferred tax asset valuation allowance. Homebuilding revenue was $2.1 billion, up 9.6% year over year.
• CPI Aerostructures Inc. (CVU) reported financial results for the third quarter of 2018. Revenue was $19.9 million, compared to $20.7 million in the previous period. Gross margin was 24.1% compared to 23.7% in the previous period. Net income for the quarter was $1.3 million compared to $1.7 million in the previous period. Net income per share was $0.15 per share, compared to the I/B/E/S consensus estimate of $0.13 per share, beating the analyst estimate by 15.4%.
• CSS Industries Inc. (CSS) reported financial results for the second quarter of fiscal 2019. Net sales were $112.9 million, an increase of 11.3% year over year. Adjusted earnings before interest, taxes, depreciation and amortization (EBITDA) was $7.9 million, compared to $10.1 million in the prior-year quarter. The company reported net loss of $4.9 million, including $5.9 million of acquisition and integration-related costs, $2.1 million of restructuring costs associated with the previously announced U.K. consolidation and $2.1 million of inventory writedown. Adjusted net income per share was $0.32 per share, disappointing the I/B/E/S consensus estimate of $0.37 per share. The company reaffirmed net sales and adjusted EBITDA guidance for fiscal-year 2019 and adjusted net loss outlook to be in the range of $10.2 million to $12.5 million, compared to a net loss of $36.5 million 2018.
• Delta Apparel Inc. (DLA) reported financial results for the fourth quarter and full year of fiscal 2018. For the fourth quarter, net sales were $92.9 million, up 2% from $91.3 million in the prior-year quarter. SG&A expenses increased $2.4 million to $17.3 million, compared to $14.9 million in the prior-year quarter. Net income was $3.1 million, an increase of $1.0 million from $2.1 million in the prior-year quarter. Diluted net income per share was $0.43 per share, beating the I/B/E/S consensus estimate of $0.22 per share by 95.5%. Fiscal full-year 2018 net sales were $395.5 million, up 3% from $385.1 million in fiscal-year 2017. Net income was $1.3 million in fiscal-year 2018. Adjusted net income, adjusted for tax expense related to tax reform legislation, was $12.0 million compared to $10.5 million in fiscal-year 2017. Diluted adjusted net income per share was $1.62, up 33% from $1.22 in the prior year.
• Ducommun Inc. (DCO) reported financial results for the third quarter ended September 29, 2018. Revenue increased 15.3% to $159.8 million from $138.7 million in the prior-year quarter. Operating income for the quarter was $6.8 million compared to $7.3 million in the comparable period last year. Net income for the quarter was $4.2 million, or $0.36 per diluted share, compared to $4.7 million, or $0.41 per diluted share, in the prior-year quarter. Analyst polled by I/B/E/S were expecting earnings of $0.28 per share, representing an earnings surprise of 25.4%.
• Hallador Energy Co. (HNRG) reported financial results for the third quarter of 2018. Total revenue was $79.72 million, compared to $74.47 million in the prior year. Tons of coal sold was 1,962 compared to 1,786 in the prior-year quarter. Adjusted EBITDA was $18.24 million compared to $21.06 million in the prior-year quarter. Net income for the quarter was $2.91 million compared to $3.92 million in the prior-year quarter. Net income per share was $0.09 per share, compared to the I/B/E/S consensus estimate of $0.13 per share, a disappointment of 30.8%.
• Kimball Electronics Inc. (KE) announced financial results for its first quarter ended September 30, 2018. Net sales increased 5% to $265.65 million, compared to $253.20 million in the prior-year quarter. Operating income fell to $7.03 million from $9.52 million in the prior-year quarter. Net income was $5.07 million compared to $8.48 million in the prior-year quarter. Adjusted net income (non-GAAP) was $4.99 million compared to $8.48 million in the prior-year quarter. Diluted net income per share was $0.19 compared to $0.31.
• Olympus Steel Inc. (ZEUS) reported financial results for the third quarter ended September 30, 2018. Net sales increased 38%, to $457 million from $331 million in net sales during the third quarter of 2017. Net income rose to $11.6 million, or $1.01 per diluted share, in the third quarter, up from $2.3 million, or $0.20 per diluted share, in the same quarter of 2017. This year’s third-quarter net income was negatively impacted by $2.7 million in last in, first out (LIFO) expense, which reduced quarterly earnings by $0.18 per diluted share. In last year’s same quarter, LIFO expense reduced net income by $0.7 million, or $0.04 per diluted share. Adjusting for LIFO impacts in both periods, third-quarter net income improved to $1.19 per diluted share in 2018, up from $0.24 per diluted share in 2017. Analysts polled by I/B/E/S were expecting earnings of $0.83 per share, compared to $1.01 per share actual, a 21.7% earnings surprise.
• PC Connection Inc. (CNXN) reported financial results for the third quarter ended September 30, 2018. Net sales as presented for the quarter were $658.5 million. Net sales prior to the impact of the new revenue recognition standard for the quarter increased by 5.1% to $766.3 million, compared to $729.2 million for the prior-year third quarter. Gross margin as presented for the quarter was 15.3%. Gross margin prior to the impact of the new revenue recognition standard was 13.1%, compared to 13.2% for the prior-year third quarter. Operating income as presented for the quarter was $19.0 million. Operating income prior to the impact of the new revenue recognition standard was $19.2 million, compared to $21.7 million in the prior-year third quarter, a decrease of 11.8%. Net income as presented for the quarter was $13.8 million. Net income prior to the impact of the new revenue recognition standard was $13.9 million, compared to $13.1 million in the prior-year third quarter, an increase of 6.2%. Earnings per share (EPS) on a diluted basis as presented for the quarter was $0.51. Earnings per share prior to the impact of the new revenue recognition standard was $0.52 per share, compared to $0.49 on a diluted basis in the prior-year third quarter. Analysts polled by I/B/E/S were expecting earnings per share of $0.50, a 2.0% surprise.
• RCM Technologies Inc. (RCMT) announced financial results for the third quarter ended September 29, 2018. Revenues were $42.6 million, a 2.9% decrease compared to $43.8 million year over year. Gross profit was $11.0 million, a 6.2% decrease compared to $11.7 million for the comparable prior-year period. Adjusted EBITDA (non-GAAP) was $1.6 million, a 21.9% decrease compared to $2.0 million for the comparable prior-year period. Operating income was $1.2 million for the current quarter, compared to $1.6 million for the comparable prior-year period. Net income was $0.7 million, or $0.06 per diluted share, for the current quarter, compared to net income of $1.0 million, or $0.08 per diluted share, for the comparable prior-year period. Analyst polled by I/B/E/S were expecting earnings of $0.50 per share.
• Renewable Energy Group (REGI) announced financial results for the third quarter. Revenues were $597.8 million, a decrease of 4.7% that was primarily due to lower revenue from sales of separated renewable identification numbers (RINs) and a lower average selling price per gallon, partially offset by the increase in gallons sold. Gross profit was $51.4 million, or 8.6% of revenues, compared to gross profit of $14.8 million, or 2.4% of revenues. Net income attributable to common stockholders was $24.3 million, or $0.53 per share on a fully diluted basis. This compares to a net loss of $11.4 million, or $0.29 per share on a fully diluted basis in the third quarter of 2017. Adjusted net income attributable to common stockholders was $19.8 million, or $0.43 per share, compared to an adjusted net loss excluding allocation of the 2017 Blenders’ Tax Credit (BTC) of $15.1 million, or $0.39 per share, on a fully diluted basis in the third quarter of 2017. Analysts polled by I/B/E/S were expected earnings per share of $0.49, a 9.3% surprise.
• REX American Resources (REX) announced financial results for the third quarter. Net sales and revenue increased 2.1% to $123.8 million, compared with $121.2 million in third-quarter 2017. REX reported income from continuing operations before income taxes and non-controlling interests in third-quarter 2018 of $3.8 million, compared with $9.3 million in third-quarter 2017. The company’s third-quarter 2018 gross profit for its ethanol and by-products segment was $11.3 million, compared with $18.3 million in third-quarter 2017, primarily reflecting lower ethanol pricing. While the refined coal operation negatively impacted gross profit and income before income taxes, the company’s refined coal operation contributed to a lower effective tax rate. Net income attributable to REX shareholders in third-quarter 2018 was $11.9 million, compared to $13.2 million in third-quarter 2017. Third-quarter 2018 basic and diluted net income per share attributable to REX common shareholders was $1.86 per share, compared to $2.00 per share in third-quarter 2017.
• Roadrunner Transportation Systems Inc. (RRTS) announced financial results for the third quarter. Revenues for the third quarter ended September 30, 2018, were $536.6 million. Revenues for the quarter ended September 30, 2017, were $521.4 million. Operating loss in the third quarter of 2018 was $10.8 million, which included corporate restructuring and restatement costs of $4.7 million. Operating income in the third quarter of 2017 was $11.3 million. Net loss increased to $41.6 million in the third quarter of 2018, compared to $10.1 million in the third quarter of 2017. Diluted loss per share available to common stockholders was $1.08 for the third quarter of 2018, compared to diluted loss per share of $0.26 for the third quarter of 2017.
• Seneca Foods Corp. (SENEA) announced financial results for the second quarter. Net continuing sales decreased $7.0 million, or 2.1% compared to the prior-year quarter. A decrease in sales volume of $10.0 million was partially offset by higher selling prices/mix of $3.0 million. Gross margin percentage from continuing operations income decreased from 6.6% to 3.4% compared to the prior-year quarter. Net diluted earnings per share were $0.92 compared to a net loss per share of $0.11 in the prior-year quarter.
• Townsquare Media Inc. (TSQ) announced its financial results for the third quarter. On a GAAP basis, net revenue increased 1.9%, and 9.5% excluding live events net revenue. Net revenue increased 0.1% excluding political revenue. Net income decreased 32.2%, and net income from continuing operations increased 38.6%. Diluted net income per share from continuing operations and diluted adjusted net income per share were $0.35 and $0.36, respectively. Analysts polled by I/B/E/S were expecting $0.36 per share, a 3.8% disappointment on diluted net income per share.
• Vishay Precision Group Inc. (VPG) announced its financial results for its fiscal-2018 third quarter. Revenues grew 20.2% year over year, to $75.5 million. Gross profit margin was 40.5% for the quarter, compared to 38.6% for the prior-year period. Operating income increased by 92% to $10.6 million compared to $5.5 million in the prior-year period. Earnings increased 75% to $0.56 per diluted share, compared to $0.32 reported last year. Analysts polled by I/B/E/S were expecting $0.49 earnings per share, a 17.5% surprise.