Model Shadow Stock Portfolio: New Rules, Including Momentum

Both small-cap and value stocks had a strong three-month period through the end of August.

The Model Shadow Stock Portfolio is up 11.8% year to date as of August 31; this compares to 7.7% for the S&P 500 as measured by the Vanguard 500 Index fund (VFINX). In both cases, the year-to-date returns portend a slightly above-average return for 2016. However, there has been a lot of volatility this year, probably justified by economic and political uncertainty.

Rule Changes

After reviewing all the research for my book, “Investing at Level3,” I have made some changes to the rules for the Model Shadow Stock Portfolio. The changes are relatively minor; only one new variable has been added—momentum. The specific changes are as follows:

• The initial maximum market capitalization was raised from $300 million to $400 million, and the sell level will now be $1.2 billion (three times the initial maximum).
• Stocks in the rental & leasing industry will be removed from consideration. The rental & leasing industry is really a part of the financial sector, which has always been eliminated. This led to selling Willis Lease Finance Corp. (WLFC).
• While stocks in the utility sector rarely pass the purchase rules, utility stocks will be removed from consideration because regulators make many of the decisions.
• The major change is the requirement that stocks be in the upper half of relative price strength for the most recent 26-week period. This means that for a stock to be considered for purchase its price has to have increased more (decreased less) relative to the market than the majority of stocks in the database. This applies to propsective purchases only; currently, the portfolio does not use a momentum-based rule for selling.

Final decisions for the actual portfolio, which can only buy when it sells, continue to be made on the basis of liquidity and any special circumstances (e.g., Chinese stocks are eliminated).

While there are other value variables that seem to increase the chance of higher returns, I feel that most of the impact is picked up by the current purchase criteria. Momentum is the exception: It is not really a value criterion, but the evidence of its favorable impact is very strong. Using the 26-week period and requiring an above-average ranking will continue to be evaluated to arrive at the best way to use momentum.

All of these rule changes are reflected in the *IISSP (Shadow Stock) screen in Stock Investor Pro, AAII’s fundamental stock screening and research database.

Portfolio Changes

The current holdings in the Model Shadow Stock Portfolio can be viewed here. New changes to the portfolio are summarized on the Transaction History page. Three stocks were removed from the portfolio:

• CDI Corp. (CDI) was sold because it violated its earnings probation;
• LMI Aerospace Inc. (LMIA) was sold because it violated its earnings probation; and
• Willis Lease Finance Corp. (WLFC) was sold because rental & leasing stocks are now being eliminated from consideration.

Five stocks qualified under the volume restriction for the actual portfolio, but one was Chinese and one was thinly traded with a wide bid/ask spread. The three stocks added to the portfolio are:

• AV Homes Inc. (AVHI),
• Beazer Homes USA (BZH), and
• Hallador Energy Co. (HNRG).

Two of these are home builders and one is an energy company. Both of these are beaten-down industries that are trying to recover, but that is typical for value companies. They are beat down sometimes for their individual stock characteristics and sometimes because of their sector or industry membership.

Changes to the AAII Model Portfolios are announced via special email alerts and web notices. Be sure you are signed up to receive these free notices. Go to www.aaii.com/email, select the Model Portfolios Update email and click Submit at the bottom of the box of email choices.

Looking Ahead

By the time my next column on the Model Shadow Stock Portfolio appears in the January AAII Journal, we will know who America’s president will be. We should also know who has control of the House and Senate. At that time, we and the market can make estimates of what tax changes and other financial impacts might occur. History is not very clear about the four-year impact on the market of various combinations of Democratic and Republican governmental control.

For news about the Model Shadow Stock Portfolio in the meantime, be sure to check the Model Portfolios area and sign up for the free Model Portfolios Update email, which includes alerts about any portfolio changes.