John Bajkowski
is the president of AAII.
The Model Shadow Stock Portfolio is reviewed quarterly to determine portfolio sales and additions, a practice put in place since the portfolio’s inception in 1993.
The quarterly review cycle of the Model Shadow Stock Portfolio is tied to the reporting cycle of most domestic publicly traded firms. After the reporting cycle is complete, holdings are examined for violating the earnings, valuation, size and age rules of the Model Shadow Stock Portfolio.
The review begins with an examination of the breakpoints for the smallest and cheapest deciles of domestically listed stocks. The primary Model Shadow Stock Portfolio selection criteria target the intersection of the smallest 10% of domestic stocks as measured by market capitalization, along with the “cheapest” 10% of domestic stocks as measured by the price-to-book-value (P/B) ratio. These decile breakpoints are determined by examining domestic companies that are listed on the New York Stock Exchange (NYSE) and then applying the size and value breakpoints for stocks listed on all domestic exchanges. Professor Kenneth R. French provides a historical review of the breakpoints on his Dartmouth faculty website. We also calculate these breakpoints using AAII’s Stock Investor Pro stock screening and analysis software program.
The price-to-book cutoff has decreased slightly from 0.89 in June to 0.88. With the current initial qualifying maximum price-to-book ratio at 0.90, we are leaving it unchanged. Qualifying stocks must have a price-to-book ratio of 0.90 or lower. Stocks in the model portfolio are sold for valuation if they exceed three times the minimum initial price-to-book ratio at the time of a quarterly portfolio review. In other words, for this quarter’s review we use a price-to-book cutoff of 0.90 to screen for stocks to add to the Model Shadow Stock Portfolio and 2.70 (0.90 × 3) as the maximum price-to-book ratio to keep stocks in the portfolio.
As of September 9, 2022, Perion Network Ltd. 
(PERI) had the highest price-to-book-value ratio in the Model Shadow Stock Portfolio. Perion Network is an Israel-based technology company that delivers online advertising solutions and search monetization to brands and publishers. Its price-to-book ratio of 1.92 is below the 2.70 value used to remove stocks from the model portfolio. Therefore, no stocks are being sold this quarter for exceeding the valuation limit of the model portfolio.
We then examined market-cap levels of the companies listed on the NYSE to determine the size cutoff for the lowest decile. Here the market-cap level maximum was $330 million, compared to $383 million in June 2022. With the current initial qualifying market cap level of $400 million, we are reducing the maximum initial market cap value to $350 million. The maximum market cap for inclusion in the Model Shadow Stock Portfolio is $350 million, and holdings are sold if their market cap goes above three times the initial criterion at the time of the quarterly review: $1.05 billion.
Perion Network also had the highest market cap in the portfolio, with a value of $948.6 million as of September 9, 2022. Its market cap was just below the removal level of $1.05 billion, so no stocks are being removed this quarter for exceeding the size limit of the model portfolio.
The other major factor that leads to portfolio turnover is tied to negative earnings. If a company reports trailing 12-month earnings from continuing operations that are negative, the stock is placed on probation; if a subsequent quarter has negative earnings prior to trailing 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. These are earnings that have been adjusted to eliminate the impact of nonrecurring events such as markdown of inventory or goodwill. These are earnings reported in the media and firms reporting consensus estimates. The I/B/E/S adjusted earnings reported in Stock Investor Pro are used for Model Shadow Stock Portfolio decisions when they are available.
Dixie Group Inc. (DXYN) reported a normalized earnings loss of $0.29 per share for its 2022 second quarter, compared to a gain of $0.21 per share for the same period one year ago. The quarterly loss moves its trailing 12-month earnings into the red and places the firm on earnings probation.
Coming into this quarter, Ampco-Pittsburgh Corp. (AP), Mesa Air Group (MESA) and Ultralife Corp. (ULBI) were on earnings probation.
Ampco-Pittsburgh and Ultralife both reported positive quarterly earnings from continuing operations. They both remain on probation until trailing 12-month earnings turn positive.
Mesa Air Group, however, reported an earnings loss of $0.20 per share on August 8, 2022, and is being removed from the Model Shadow Stock Portfolio.
After conducting the quarterly review of the Model Shadow Stock Portfolio, Mesa Air Group was removed from the tracking portfolio during regular trading hours on Monday, September 12. With the proceeds from the sale, as well as the cash held in the portfolio, there were enough funds to purchase one new holding at a level roughly matching the average position—NACCO Industries Inc. (NC).
Mesa Air Group (MESA)
Headquartered in Phoenix, Arizona, Mesa Air Group is the holding company of Mesa Airlines, a regional air carrier providing scheduled passenger service to 121 cities in 41 states, the District of Columbia, the Bahamas and Mexico, as well as cargo services out of Cincinnati/Northern Kentucky International Airport. As of June 30, 2022, Mesa Air operated a fleet of 168 aircraft with approximately 360 daily departures and 2,600 employees. Mesa Air operates all of its flights as either American Eagle, United Express or DHL Express flights.
Mesa Air Group noted that while demand remained strong, its financial results were hurt by a lack of pilots, both from attrition of existing pilots and fewer new pilots in the “commercial pilot pipeline” who must complete 1,500 flight hours before they can work at an airline. Many senior pilots took early retirement packages at the major airlines, allowing regional pilots move up, but leaving the regional airlines with a shortage of pilots. In 2013 the flight requirement for new airline pilots was increased from 250 hours to 1,500 hours, following the 2009 crash of Colgan Air flight 3407, which crashed primarily due to pilot error.
It is the policy of the Model Shadow Stock Portfolio to sell a stock once its trailing 12-month adjusted earnings go negative and the company reports a quarterly loss in a subsequent quarter while trailing earnings are still negative.
Mesa Air Group is being removed from the portfolio because of the Model Shadow Stock Portfolio’s negative earnings rule. Mesa Air Group reported an adjusted earnings loss of $0.20 per share, while trailing adjusted earnings per share remained in the red. Adjusted trailing 12-month earnings per share first turned negative on May 9, 2022, when the company reported a loss of $0.29 per share on adjusted quarterly earnings.
Mesa Air Group was purchased for the Model Shadow Stock Portfolio on June 4, 2019, at a purchase price of $8.95. It was sold on September 12, 2022, for $2.40 per share, for a loss of 73.2%.
As of September 9, 35 stocks met the initial selection criteria for the Model Shadow Stock Portfolio. This is up from 28 passing companies last month, even after tightening the maximum market-cap level from $400 million to $350 million. 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 new Shadow Stock Ideas is updated daily—Tuesday through Saturday.
Nine stocks already in the Model Shadow Stock Portfolio passed the updated criteria at the time of the review: Container Store Group Inc. (TCS), Delta Apparel Inc. (DLA), Fonar Corp. (FONR), Hooker Furnishings Corp. (HOFT), Hurco Companies Inc. (HURC), Key Tronic Corp. (KTCC), Pangaea Logistics Solutions Ltd. (PANL), SigmaTron International Inc. (SGMA) and Strattec Security Corp. (STRT).
The remaining 26 stocks were examined to ensure adequate liquidity, timely financial filings and appropriate industry and foreign considerations. Four securities were eliminated because they were limited partnerships or had ties to China. Seven stocks were also excluded from consideration because their average daily dollar trading volume was too low, indicating that they might be difficult to purchase without severely impacting the share price.
The Shadow Stock Portfolio Rules on AAII.com provides guidance on factors to consider when selecting stocks for your portfolio.
Price momentum is used as the tiebreaker among qualifying stocks. The remaining 15 stocks were ranked using the weighted relative strength ranking, which considers price performance over the last year but places a higher weight on the most recent quarterly price performance.
With the proceeds from the Mesa Air Group sale and the existing cash position of the Model Shadow Stock Portfolio, there were enough funds to take a position in one company at roughly the average position size for the existing holdings in the tracking portfolio. The portfolio addition is:
NACCO Industries, Inc. (NC)
NACCO Industries is a holding company operating through three business segments: coal mining, North American Mining and minerals management. The coal mining segment operates surface coal mines for power generation companies and an activated carbon producer. The North American Mining segment is a mining partner for producers of aggregates, lithium and other minerals. The minerals management segment acquires and promotes the development of mineral interests. The company also provides stream and wetland mitigation solutions.
NACCO Industries has a book value per share of $54.93 as of June 30. If you wish to stay within the 0.90 price-to-book-value maximum, you should pay no more than $49.44 per share ($54.93 × 0.90). However, if the stock price has moved up after being added to the portfolio, you can still purchase the stock unless the price-to-book ratio goes above 1.00, which equates to a price of $54.93 per share. To calculate the maximum purchase price based on the maximum desired price-to-book ratio, multiply the current book value per share ($54.93 for NACCO Industries) by the maximum price-to-book ratio to be considered for the Model Shadow Stock Portfolio (currently 0.90, or 1.00 for loosened consideration).
The next quarterly review of the Model Shadow Stock Portfolio will take place following the end of November 2022. Any changes to the portfolio will be announced at the time they are made in our Model Shadow Stock Portfolio Update emails (sign up at www.aaii.com/email).
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