Investing is not always easy.
A great deal of research supports the notion that over the long term, stocks of smaller companies have had greater returns than those of larger companies. The research also shows that low price-to-book-value ratio stocks have had higher returns over the long term than glamour (high price-to-book-value) stocks—and this was in addition to any smallness effect. The Model Shadow Stock Portfolio was designed to capture the benefit of these observations.
To realize those higher long-term gains, however, you have to be willing to expect some periods of underperformance. You also have to be able to accept greater short-term volatility from small-cap stocks, with the understanding that your long-term wealth accumulation should benefit from your patience.
So far, 2018 is certainly testing the patience of small-cap value investors. As of February 28, 2018, the Model Shadow Stock Portfolio was down 9.3% year to date, compared to a 1.8% gain for the S&P 500 index as measured by the Vanguard 500 Index fund 
(VFINX). The Vanguard Small Cap Index fund (NAESX) is down 1.3% year-to-date.
The portfolio’s performance this year has been influenced by significant declines of a handful of holdings, most of which still qualify under the value and size rules for being added to the portfolio. The Model Shadow Stock Portfolio reflects the philosophy that success comes more from concern for the overall portfolio than for individual stocks. The portfolio rules focus on building a portfolio of stocks possessing the attractive characteristics as highlighted by sound academic research coupled with portfolio management rules aimed at controlling emotional behaviors that normally reduce long-term aftertax returns of managing a portfolio of micro-company stocks.
As noted by AAII founder James Cloonan when he started this model portfolio, for those willing to spend more time managing their portfolios, additional screens and quantitative analysis can be used. Keep in mind that research continually shows that, among individuals and professional investors alike, those with a consistent approach win and those who keep changing strategies lose.
After conducting our quarterly review of the Model Shadow Stock Portfolio at the end of February, none of the current Shadow Stock holdings met any of the portfolio’s sell rules in terms of earnings, price-to-book ratio or market capitalization. However, Hardinge Inc. (HDNG) announced that it had entered into a definitive merger agreement to be acquired by an affiliate of Privet Fund Management LLC for $18.50 per share in cash. Therefore, Hardinge was sold from the portfolio.
With the proceeds from the Hardinge 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.
Ten stocks passed the screen based on the liquidity requirements at the time of the review, but the portfolio already held all but two stocks. The four-week relative strength price ranking was used to select the Container Store Group (TCS) for the Model Shadow Stock Portfolio.
The current list of Shadow Stocks can be accessed here.
James Cloonan introduced AAII members to the principles and rules of the Model Shadow Stock Portfolio in his January 1993 article that was simply titled “Thinly Traded Stocks: Putting a Practical Approach to the Test.” He felt that individual investors could effectively construct and manage a micro-cap portfolio and profit from the challenges that institutional investors faced competing in that segment of the stock market.
We thank James Cloonan for his contributions, and we pledge to continue in his steps of using curiosity, passion and intellect to “share with you the problems of dealing in thinly traded stocks.”
You can follow the Model Shadow Stock Portfolio in the Model Portfolios area. To receive monthly email updates along with alerts to any changes made to the portfolio, please go to www.aaii.com/email.
Get updates about the portfolio that has outperformed the market by 211.9%
since inception!
