November Model Shadow Stock Portfolio Update

As of the end of October, only 16 stocks met the initial selection criteria for the Model Shadow Stock Portfolio, down from 34 passing stocks at the end of September. This is a major reversal of the trend that we witnessed this year and reflects the recent strong relative performance of small-cap stocks. AAII members can see and research which companies are currently passing the initial selection criteria in the Shadow Stock Ideas table on AAII.com. The list of Shadow Stock Ideas is updated daily—Tuesday through Saturday.

Of the 16 qualifying companies at the end of the month, five are currently held in the Model Shadow Stock tracking portfolio: Container Store Group Inc. (TCS), Covenant Transportation Group (CVTI), Mesa Air Group (MESA), Olympic Steel Inc. (ZEUS) and Universal Stainless & Alloy Products (USAP). CPI Aerostructures Inc. (CVU), Hooker Furniture Corp. (HOFT) and Hurco Companies Inc. (HURC) came off the list of qualifying companies over the course of the last month. Qualifying companies are those held in the Model Shadow Stock Portfolio that currently meet the initial purchase rules. (They are designated as “qualifies” in the notes column of the Model Shadow Stock Portfolio table on AAII.com. However, if you go online, the notes may not match the list here since the notes on the website table are dynamically updated daily.)

At the end of the month, PC Connection Inc. (CNXN) had the highest price-to-book-value ratio in the Model Shadow Stock Portfolio. Its ratio of 2.20 is well above the 1.00 maximum value used for initially qualifying a stock for inclusion to the portfolio. However, stocks are not removed from the portfolio until their price-to-book-value ratio rises to three times the initial maximum value. It may help you to think about values below 1.00 as being attractive, while values three times above the initial maximum are expensive. Allowing the price-to-book ratio to expand for stocks that you own allows your winners to run up a little, since the price-to-book ratio typically gets larger as the stock price goes up. The initial price-to-book level is adjusted over time to reflect the changing market conditions, and we are examining valuation and size now for the next quarterly portfolio review.

The Model Shadow Stock Portfolio looks for stocks with a market capitalization (share price times shares outstanding) less than $400 million. Shadow Stocks with a market cap three times the initial market cap maximum ($400 million × 3 = $1.2 billion) at the time of a quarterly review are sold from the portfolio, assuming there is a suitable replacement. PC Connection is approaching the market cap cut-off of $1.2 billion. PC Connection had a month-end market cap of $1.162 billion and has been flirting with the upper limit over the course of the year.

Click here to see the current purchase and sell rules for the portfolio.

Performance Update

The stock market continued its strong run in October, with the S&P 500 index finishing the month at 3,046.77 for a monthly gain of 0.6%. The stock prices of technology stocks were particularly strong performers during the month, with the Nasdaq 100 gaining 4.4% during October. The Model Shadow Stock Portfolio gained 4.8% during October and is now up 12.1% year to date. The S&P 500 as measured through the Vanguard 500 Index fund (VFINX), was up 2.2% during October, boosting its year-to-date performance to 23.1%. The S&P MidCap 400 index was up 1.1% during October and is now up 19.2% for the year, while the Russell 2000 index gained 2.6% during the month and is up 17.2% year to date. The Vanguard Small-Cap Index fund (NAESX) was up 1.6% during the month and has a year-to-date performance of 19.5%, while the DFA U.S. Micro Cap fund (DFSCX) was up 2.1% during October and is up 13.0% for this year through the end of October.

The performance of growth- versus value-oriented stocks was generally slanted toward value stocks during the month, with value stocks outperforming their growth counterparts within the large- and mid-cap segments.

In the large-cap segment, value stocks were up 2.7% for the month, bringing their year-to-date performance up to 23.2 % for 2019. Large-cap growth stocks are now weaker year to date with a 23.2% gain and were up 1.7% during October.

In the mid-cap segment, value stocks are up 18.9% for the year, after gaining 1.3% during October. Mid-cap growth stocks are up 19.4% for the year, after gaining 0.9% during the month.

Small-cap value stocks are up 15.5% year to date, while small-cap growth stocks are up 18.6%. Small-cap value stocks gained 2.4% during October, while small-cap growth stocks gained 2.9% during the month.

Stocks in the information technology (+36.5%), telecom services (+25.4%) and utilities (+24.4%) sectors are leading the market this year. Sectors that are lagging this year include energy (+4.0%), pharmaceuticals (+6.0%) and health care (+11.0%). All the sectors are up for the year, but there is a large difference between the top- and bottom-performing groups.

Since its inception in 1993, the AAII Model Shadow Stock Portfolio has a compound annual average return of 14.1% versus the Vanguard 500 Index fund’s gain of 9.5% per year on average over the same period. Over the same period, the Vanguard Small-Cap Index fund posted an average annual gain of 9.9%.

Model Shadow Stock Portfolio News

Big 5 Sporting Goods Corp. (BGFV) was the strongest stock in the Model Shadow Stock Portfolio with its 53.9% gain for October. Big 5 Sporting Goods is a sporting goods retailer in the western U.S. As noted below, Big 5 Sporting Goods reported that same-store sales increased by 0.3% for the third quarter of 2019, which represents the company’s fourth consecutive quarter of positive same-store sales. Gross profit margin for the quarter was 32.3% of sales, compared to 31% of sales in the third quarter of 2018. Net income of $6.4 million and diluted earnings per share of $0.30 were up 106% and 100% year over year, respectively. Big 5 Sporting Goods is not currently followed by any analysts.

Rocky Brands Inc. (RCKY) was the weakest stock in the Model Shadow Stock Portfolio, dropping 16.3% during October. Rocky Brands is a designer, manufacturer and marketer of footwear and apparel that is adjusting to the increased tariffs. As noted below, Rocky Brands reported net sales for the third quarter of 2019 of $67.2 million, up 2% year over year. Earnings per diluted share were $0.75, up 12% from the third quarter of 2018. Adjusted earnings per diluted share of $0.68 beat the I/B/E/S consensus estimate of $0.63 by 8%.

The next quarterly review of the AAII Model Shadow Stock Portfolio will take place around the end of November 2019, after most of the Shadow Stock holdings have announced their quarterly earnings. Any changes to the portfolio will be announced at the time they are made in a special Model Shadow Stock Portfolio Update email (sign up at www.aaii.com/email).

Here are some news highlights from October for the holdings in the Model Shadow Stock Portfolio:

Big 5 Sporting Goods Corp. (BGFV) reported net sales for the third quarter of 2019 of $266 million, flat year over year. Net income of $6.4 million and diluted earnings per share of $0.30 were up 106% and 100% year over year, respectively.

Same-store sales increased by 0.3% for the third quarter of 2019, which represents the company’s fourth consecutive quarter of positive same-store sales. Gross profit margin for the quarter was 32.3% of sales, compared to 31% of sales in the third quarter of 2018.

For the fiscal-2019 fourth quarter, Big 5 Sporting Goods expects same-store sales to be in the positive low-single-digit range and expects to realize a loss per share in the range of $0.04 to $0.16, compared to a same-store sales increase of 1.1% and a loss per share of $0.24. Fourth-quarter earnings guidance reflects an expectation for continued merchandise margin expansion. Big 5 Sporting Goods expects full-year earnings to be in the range of $0.22 to $0.34 per diluted share.

Big 5 Sporting Goods also declared a regular quarterly dividend of $0.05 per share, in line with the previous declaration. The dividend is payable December 12 to shareholders of record November 29. The stock will trade ex-dividend on Thursday, November 28.

Container Store Group Inc. (TCS) reported net sales of $236.4 million for the third quarter of 2019, up 5.3% year over year. Adjusted earnings per share of $0.080 were down 20% year over year and missed the I/B/E/S consensus estimate of $0.093.

Net sales for the Container Store retail business were $221.2 million, up 5.9%. Comparable-store sales increased 5.4%, with custom closets up 9.3% and providing the majority of the increase in comparable-store sales. Earnings per share were impacted by a charge of $0.05 per share from the setup of the company’s second distribution center in Maryland.

Container Store expects full-year earnings per share of $0.41 to $0.51, an update toward the lower end of previous guidance due to headwinds related to marketing costs for the custom closets business and the new distribution center. Full-year consolidated sales and comparable-store sales are expected to be slightly above the previous guidance of $915 million to $925 million.

Covenant Transportation Group (CVTI) reported total revenue of $222.9 million for the third quarter of 2019, a year-over-year decrease of 8.4%. Net loss for the quarter was $0.17 per diluted share, which compares to net income of $0.63 per diluted share from the third quarter of 2019. Adjusted loss per share of $0.08 missed the I/B/E/S consensus estimate of $0.03.

Freight revenue of $199.8 million decreased by 6.9% year over year. Covenant Transportation said the freight environment was weaker in 2019 than in 2018, as excess industry-wide trucking capacity and weak shipping demand pressured both volumes and rates. Covenant Transportation said that it believes the freight environment hit a low point in the third quarter but is not worsening.

Looking forward to the fourth quarter, Covenant Transportation expects low volumes and rates to remain. The company expects consolidated adjusted net income to improve sequentially to a profitable level in the fourth quarter, as combined insurance and capital costs decrease.

CPI Aerostructures Inc. (CVU) is the recipient of an indefinite delivery/indefinite quantity (IDIQ) contract with Boeing Co. (BA) with a value ceiling of $48 million to provide structural assemblies for the A-10 Thunderbolt II jet aircraft. CPI Aerostructures received initial purchase orders under the contract valued at about $6 million for delivery in late 2020. Boeing stated its intention to place more orders before May 2020 with a value between $9.1 million and $14.7 million for deliveries commencing in 2021.

Separately, CPI Aerostructures was selected by Raytheon Co. (RTN) to produce electrical pod structures, a contract valued at about $2.3 million. The first delivery is expected in 2020.

Delta Apparel Inc. (DLA) reported anticipated overall net sales for the fourth quarter of 2019 in a range of $104 million to $106 million, a 12% to 14% increase year over year. Growth was driven by organic sales growth across all the company’s businesses. Net sales for full-year 2019 are expected to grow about 8% to 9% year over year to between $428 million and $430 million.

The annual growth was driven primarily by gains in Delta Apparel’s digital print business, DTG2Go, which continues to expand through investments in print capacity, new technology and additional facilities. The company’s Salt Life business’ top-line performance is also accelerating, driven by product expansions and momentum with national and regional retailers.

Ducommun Incorporated (DCO) reported a year-over-year increase of 13% in revenue to $181.1 million for the third quarter of 2019. Earnings per diluted share of $0.70 were up 94% year over year and beat the I/B/E/S consensus estimate of $0.62 by 13%.

Gross profit for the quarter increased 170 basis points to $38 million due to improved operating leverage and operations performance. Results included favorable manufacturing volume, favorable product mix and manufacturing efficiencies.

Ducommun CEO Stephen Oswald said the company expects 2019’s strong performance to carry over into 2020 on both the top and bottom lines. Despite the uncertainty of the Boeing 737 MAX’s return to service, Ducommun said it has a good balance in its portfolio with defense business and other commercial platforms.

Flexsteel Industries Inc. (FLXS) reported net sales for the first quarter of 2020 of $100.3 million, down 12% year over year. Earnings per diluted share were $1.17, compared to $0.16 per diluted share in the same period last year. Adjusted earnings per diluted share were flat.

Residential net sales declined by 8% year over year. The ongoing 25% tariff and the resistance of customers and consumers to price increases continued to pressure sales. Contract net sales fell 33%, due largely to Flexsteel’s planned exit of the commercial office and custom-designed hospitality product lines, along with softer demand in the company’s vehicle and health care businesses.

Flexsteel said it continues to shift business out of China, as about 42% of the company’s sales are exposed to tariffs. The import volume from China was down about 18% for the quarter sequentially.

Hallador Energy Co. (HNRG) declared a regular quarterly dividend of $0.04, in line with the previous declaration. The dividend was payable November 15 to shareholders of record October 31. The stock traded ex-dividend Wednesday, October 30.

New Home Company Inc. (NWHM) reported total revenues for the third quarter of 2019 of $165.6 million, up 4% year over year. Net loss for the quarter was $0.23 per diluted share, compared to earnings per diluted share of $0.12 in the same period one year ago. Adjusted earnings per diluted share of $0.01 missed the I/B/E/S consensus estimate of $0.02 by 50%.

Home sales revenue was relatively flat year over year at $118.8 million. The slight decrease was driven by 5% fewer deliveries, partially offset by a 4% increase in average selling price to $958,000. Net new home orders for the 2019 third quarter decreased by 6%. The dollar value of New Home Co.’s backlog at the end of the quarter was down 40% year over year to $185.8 million due to a lower backlog beginning the quarter and a higher backlog conversion rate of 60% compared, year over year, to 42%.

For the fourth quarter of 2019, New Home Co. is expecting home sales revenue between $140 million and $160 million and fee building revenue between $20 million and $30 million. Home sales gross margin is expected between 12.0% and 12.3%.

PC Connection Inc. (CNXN) reported net sales of $729.4 million for the third quarter of 2019, a year-over-year increase of 11%. Earnings per diluted share of $0.90 were up 76% and beat the I/B/E/S consensus estimate of $0.573 by 57%.

Notebook/mobility sales—PC Connection’s largest product category—increased by 20% year over year and accounted for 30% of net sales, up from 28% one year ago. Desktop sales increased by 33% year over year, also contributing to the quarter’s growth. The company said it experienced a strong business environment during the third quarter when compared year over year.

Looking forward, CEO Timothy McGrath said the company’s plan continues to be to grow at twice the pace of its overall market. PC Connection’s current industry growth expectations are in the low-single digits.

RCI Hospitality Holdings (RICK) reported total sales for the fourth quarter of 2019 of $44 million, up 12% year over year. Consolidated same-store sales were up 1.5% to $38 million. Compared to 2018, nightclub same-store sales were fairly flat; Bombshells same-store sales were up 19%, to $5.3 million.

“Both new and existing nightclubs and Bombshells continued to perform well in fourth-quarter 2019, producing record total club and restaurant sales for both the quarter and the year,” said CEO Eric Langan. “Restaurant same-store sales are now up double-digits year over year four months in a row.”

Rocky Brands Inc. (RCKY) reported net sales for the third quarter of 2019 of $67.2 million, up 2% year over year. Earnings per diluted share were $0.75, up 12% from the third quarter of 2018. Adjusted earnings per diluted share of $0.68 beat the I/B/E/S consensus estimate of $0.63 by 8%.

Wholesale sales increased 0.4% to $47.2 million; retail sales increased 21.8% to $14.5 million; and military segment sales decreased, as expected, to $5.4 million. Higher retail sales pushed the quarter’s gross margin up 320 basis points to 37% of sales. Rocky Brands’ retail business carries a higher gross margin than wholesale and military margins.

Rocky Brands said it still expects revenues to increase in the mid-single-digit range over 2018 for full-year 2019. Gross margins are expected to be impacted in the short term by China tariffs, though the company said it should be able to mitigate these headwinds. Even so, profitability is not expected to improve much year over year for the fourth quarter of 2019.

Strattec Security Corp. (STRT) reported a 2% increase to net sales of $120 million for the first quarter of 2020. Earnings per diluted share were $0.33, down 65% year over year. Strattec Security recorded a compensation charge of $2.2 million related to the transfer of assets out of the company’s terminated pension plan. Adjusted for this charge, earnings per diluted share of $0.79 were down 5% year over year.

Sales to General Motors Co. (GM) were up 34% to $33.8 million compared to the same period in 2018, despite a $3 million impact from the General Motors labor strike. Sales to Fiat Chrysler were down 15% to $25.8 million. Sales to commercial and other original equipment manufacturer (OEM) customers during the quarter increased slightly to $21.3 million in comparison to the prior-year quarter mainly due to higher sales volumes related to Strattec Security’s aftermarket business.

Strattec Security also declared a regular quarterly dividend of $0.14, in line with the previous declaration. The dividend is payable December 27 to shareholders of record December 13. The stock will trade ex-dividend on Thursday, December 12.

Universal Stainless & Alloy Products Inc. (USAP) reported net sales of $56.6 million for the third quarter of 2019, down 18% year over year. Earnings per diluted share were $0.09, which missed the I/B/E/S consensus estimate of $0.21 by 57% and decreased 80% year over year.

Aerospace sales improved 17% year over year and contributed 72% of total sales for the third quarter. However, operations were negatively impacted by increased downtime and production delays in key units, which resulted in delayed shipments worth about $6 million of net sales. At the close of the third quarter, Universal Stainless & Alloy Products made substantially all necessary repairs at impacted units.

Looking at the fourth quarter, Universal Stainless & Alloy Products said it expects sales to be up sequentially from the third quarter’s disappointing results. Margins are also expected to return to what the company has seen in the last couple of quarters, as the negative incidents impacting third-quarter results are not expected to carry forward.

VSE Corp. (VSEC) reported that revenue of $198 million increased by 17% year over year for the third quarter of 2019. Earnings per diluted share were $0.95, up 3.3% compared to the third quarter of 2018.

Revenues for VSE Corp.’s Federal services group were about flat year over year at $83.7 million; revenues for the aviation group increased about 74% to $59.2 million; and revenues for the supply chain management group increased about 7% to $55.4 million. The aviation group benefited from an acquisition completed in January 2019 and organic growth in both its distribution and repair businesses.

“We successfully executed on growth initiatives and the results reflect strong third-quarter increases in both our aviation and supply chain management groups,” said CEO John Cuomo. “Both businesses have clearly defined strategies for growth and proven success in test markets.”