AAII Model Shadow Stock Portfolio User Guide

The Model Shadow Stock Portfolio provides guidance for investing in the promising micro-cap value sector of the market. The portfolio was initially conceived to show the membership of AAII how to capitalize on the most promising academic research to manage a stock portfolio without having to commit a great deal of time and effort to day-to-day monitoring. In fact, AAII manages this model stock portfolio by simply reviewing holdings on a quarterly basis.

A True Do-It-Yourself Model

To pick the right stocks for AAII’s Model Shadow Stock Portfolio, the focus is primarily on portfolio formation and risk reduction. The stocks in the AAII Model Shadow Stock Portfolio are largely risky stocks when evaluated separately. But when taken together as a portfolio, most of that individual stock risk has been diversified away. In fact, the average risk of the individual stocks has been reduced by about 70%. The central point of our Model Shadow Stock Portfolio is that the risk of any individual stock is not important if your portfolio is well diversified. What is important is how the addition of that stock affects the risk of your overall portfolio.

If you are not following the full model portfolio but instead using the list of stocks as a tool to generate investment ideas, it is suggested that you adhere to the overall strategy by selecting and monitoring a portfolio that consists of at least 10 stocks. Choosing stocks in different sectors will provide added diversification and protect your portfolio from some sector volatility. Furthermore, be sure to consider fees when making your investments. While there is no recommended minimum, investments should be large enough so that fees are insignificant.

While the Model Shadow Stock Portfolio minimizes risk, it is still prudent to take into account your personal risk tolerance. Investors are rightly worried about the amount they invest in a micro-cap strategy. Even a properly diversified micro-cap portfolio will be more volatile than the total market because these stocks are inherently more risky. The worst time to sell a stock is at the bottom, so be sure not to put so much weight into your micro-cap portfolio that you cannot stomach the losses. Keep in mind that due to the nature of the Model Shadow Stock Portfolio, it will offer very little income in the form of dividends.

Two Ways to Build Your Own Shadow Stock Portfolio

Follow the guidance provided here and discussed in the AAII Model Portfolios articles in the January, April, July and October AAII Journals. Remember, this portfolio was designed to require only simple modifications on a quarterly basis when company fundamentals change.

~ OR ~

Utilize the online resources at the Shadow Stock Ideas page, where you can see a daily-updated list of potential Shadow Stocks. The Shadow Stock Ideas list shows all the companies that currently meet the criteria of the Shadow Stock screen. However, the stocks that appear on the Ideas list might not be added to the model portfolio. Alternatively, you can start with the stocks in the Model Shadow Stock Portfolio that are marked as “currently qualifies” in the Notes column. This shows you which model portfolio holdings still meet the portfolio addition rules using current data. (Stocks not marked as “currently qualifies” will continue to be held in the portfolio until they meet one of the portfolio deletion rules. Keep in mind that changes are only made to the model portfolio holdings quarterly.)

Ongoing Management of Your Portfolio

AAII’s Model Shadow Stock Portfolio is not intended to be an advisory service in the usual sense of that term—that is, it is not intended to be a list of individual stock recommendations. Instead, the model portfolio serves to show you how to use a value-oriented approach to select micro-cap stocks in an effort to build your own Shadow Stock Portfolio. Profitable micro-cap investing requires extra care. The portfolio construction and monitoring rules were developed over the years to minimize costs and maximize profits.

In the pages of the AAII Journal, you can read quarterly commentary on the Model Shadow Stock Portfolio (which has been running for 30 years). The AAII Shadow Stocks area of AAII.com presents the detailed rules for building and managing a Shadow Stock Portfolio, as well as a monthly list of stocks that currently meet the criteria for inclusion.

Ongoing performance of AAII’s Model Shadow Stock Portfolio is tracked online, but keep in mind that a portfolio can be built by simply following the investment moves outlined in the AAII Model Shadow Stock Portfolio articles found quarterly in the AAII Journal (and archived at the Journal Commentary page on the AAII Shadow Stocks site).

Portfolio Management Criteria

A quarterly review of the following addition, deletion and management criteria is all that should be needed to build your own Shadow Stock Portfolio. Simply review your holdings on a quarterly basis to see if any fundamental changes make them candidates for sale (see deletion rules below). If you have new investment funds available or cash from sales, you can look at the list of Shadow Stock Ideas to see if any companies meet your needs for inclusion in your Shadow Stock Portfolio.

Stock additions must meet these criteria:

• Price-to-book-value (P/B) ratio must be less than or equal to 1.00. If the price-to-book ratio moved up a bit since the stock was included in the portfolio, it is OK to purchase the stock unless this ratio goes above 1.10.*
• Market capitalization must be between $30 million and $400 million.*
• The firm’s last quarter and last 12 months’ earnings from continuing operations must be positive.
• The share price must be greater than $4.
• No bulletin board or pink sheet stocks will be purchased.
• No stocks in the utility sector will be purchased.
• No financial stocks, including those in the rental and leasing industry, or limited partnerships will be purchased.
• No foreign stocks 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.
• Any stock that was removed within two years will not be added back.
• Note second item under stock order guidance (below) concerning spreads when buying shares.
• Eliminate any company that failed to file a Form 10-Q (quarterly) in the last six months.
• The AAII A+ Momentum Score is used as a tie-breaker among qualifying stocks. This score ranks stocks based on their weighted four-quarter relative strength index.

*These figures will change gradually as market values change. Any changes will be noted in the AAII Journal and online.

Stocks are deleted if any of the following occur:

• The stock reports a string of negative earnings:
  —If last 12 months’ earnings 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 removed. When available, adjusted (non-GAAP) earnings are used to put stocks on probation or remove 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, provided in press releases and used in estimates of future earnings. Adjusted earnings are used because the information appears much sooner than official filing data. Otherwise, earnings from continuing operations are used.
• The stock’s price increases so that it is no longer considered a small/micro-cap value stock:
• —The stock’s price-to-book ratio goes above three times the initial criterion.
  —Market cap goes above three times the initial maximum criterion.
• Stocks that have been held for four years are deleted unless:
  —They currently qualify,
  —They are up more than 40% from their addition, or
  —There is no qualifying stock to replace them.
  If a stock has been held for over four years, it needs to be up 10% per year held to avoid being deleted (for example, a stock held for six years needs to be up 60%). Time and return are based on the initial addition for the portfolio.

In summary, stocks are removed when the market recognizes the value of one of the portfolio holdings, thus driving up the price so that it no longer remains in the “shadows” of Wall Street.

Stock order guidance:

• These rules are for general guidance. Your own experience, market conditions and size of position will impact decisions.
• 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 10 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 the price-to-book ratio or market cap) when only part of the order has been filled, shares already purchased are kept but the balance of the order is canceled.

Management rules:

• Equal dollar amounts are invested in each stock initially.
• Decisions are made only once per quarter. In order to react to the majority of earnings reports as soon as possible, quarterly reviews are done at the beginning of March, June, September and December.
• Best judgment is used for tenders or mergers, but all criteria must be obeyed.
• At the end of a quarter, if receipts from stocks removed exceed requirements for available new purchases, the excess receipts are kept in cash until the next quarter. If too much cash is accumulated, the rules will be adjusted.
• After a quarterly review, if proceeds from stock deletions are insufficient to add all newly qualifying stocks, additions are based upon the weighted four-quarter relative strength rank.
• 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 are not needed until the portfolio exceeds $1 million.

Getting Started: AAII Model Shadow Stock Portfolio

AAII communicates information about the Shadow Stock Portfolio to our membership via the AAII Journal, the AAII Shadow Stocks area and email. Performance information, news and commentary are always posted and kept up to date at www.aaii.com/model-portfolios.

Once per month, a Model Portfolios Update email is sent to interested members with commentary, updated performance figures and news on the stocks in the portfolio. Addition and deletion alerts, if any, are also reported in the monthly email. You can sign up to receive this free email by going to www.aaii.com/email.

You are encouraged to study this guide, read the Journal Commentary articles and visit the other pages of the AAII Shadow Stocks area prior to investing in any stocks.