Revised Guidance on Following the Model Shadow Stock Portfolio

The weakness in micro-cap stocks continues.

As of November 30, 2015, the Model Shadow Stock Portfolio was down 13.2% year to date, compared to a 2.9% gain for the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX). Even if there is a Santa Claus rally, it seems likely 2015 will be one of the worst years for the portfolio. The results for longer periods can be seen in the Historical Return Chart and Year-to-Year Performance page.

As I look back at the weak performance, it seems very earnings-related—overall, earnings have been below expectations. I have the feeling that this is true of much of the equity market, but it seems to have impacted the smallest stocks the most. Perhaps smaller stocks react primarily on company performance, while the larger-cap stocks are impacted by geopolitical happenings, Federal Reserve activity, economic predictions and other external events.

Rule Changes

There are no rule changes, but I do want to make an adjustment in the section on stock order guidance.

Previously, when I have discussed the need for liquidity, I suggested that the average daily dollar volume of a stock should be at least four times the size of the position you wish to create. I now feel that this should be increased to 10 times the desired position size.

For example, if you wish to establish a position of $10,000 in a stock, then you should restrict choices to stocks with $100,000 average daily volume. This will make getting in and getting out of the stock much more efficient.

Along those lines, I require an average daily volume of $300,000 for the stocks I select for the Model Shadow Stock Portfolio. This is why the number of stocks passing my screen is less than the number of stocks that qualify under the basic rules.

See the Shadow Stock Portfolio Rules page for the complete list of rules.

A Note on Our Performance

Perhaps you saw the article on AAII’s Model Shadow Stock Portfolio in the November 7, 2015, Wall Street Journal by Jason Zweig. He mentioned there might be biases that impact how well investors using Shadow Stock holdings might do relative to the portfolio’s actual performance.

I have discussed this before, but it seems a good time to revisit the subject. I see three factors that can impact your results if you emulate the portfolio.

1. Since the model portfolio and any variations of it are real portfolios, the money invested is finite. When the portfolio is out of money new stocks, no matter how appealing, cannot be bought until there are sales. Since different investors may be fully invested at different times, it is likely that no two portfolios will be the same even though they are following the same rules. This bias should be neutral, on average.
2. Since the Model Shadow Stock Portfolio buys stocks and then announces its actions, the impact of others buying the same stocks later should be beneficial to the model portfolio. This is a positive bias to the model portfolio and makes its returns higher than they might otherwise be.
3. Since the model portfolio rules are spelled out in detail and always followed by us, anyone is free to take positions prior to our announcement. This could be done a day or a month ahead. When there are many qualifying stocks, any estimate of which stocks will actually be bought may be a bit off, but we are very open about our procedures. This bias is negative and makes the model portfolio returns less than they might be. We know some of this activity takes place.

Overall, we still feel that the best way to use the model portfolio is as a starting point from which you can develop your own individual approach.

Portfolio Changes

Olympic Steel (ZEUS) was sold because it violated earnings probation.

We bought two new stocks with the proceeds: Seneca Foods Corp. (SENEA) and Townsquare Media Inc. (TSQ).

We had 15 qualifying stocks after applying our $300,000-a-day volume requirement. Two of these stocks were already owned: Key Tronic Corp. (KTCC) and Rocky Brands Inc. (RCKY). There were no Chinese stocks this time, which we suggest avoiding due to their data uncertainty.

We basically narrowed it down to the stocks with the lowest price-to-book-value ratios (P/Bs), with a few decisions based on liquidity.

Current holdings in the Model Shadow Stock Portfolio can be seen here, and the Transaction History page shows the fourth-quarter transactions.

Special Circumstances

Willis Lease Finance (WLFC) has offered to buy back shares on a variation of a Dutch auction basis. We are not participating since we have no reason to sell the stock at this time.

Global Power Equipment Group (GLPW) has still not provided corrected updates on their financials for 2013 and 2014. The New York Stock Exchange (NYSE) has given them an extension until March 31, 2016, before considering delisting the stock. The company appears to be working out problems with lenders. We will not take any action at this time.

We have had a number of requests to provide the changes in the portfolio sooner than we do now and are looking into the possibility for next year.

Looking Ahead

The market situation remains the same, with a number of positive and negative influences. Action by the Fed will likely have occurred by the time you read this. We enter a presidential election year, and the Republican candidate is still a mystery. The world situation is volatile and there is domestic unrest. Through all of this, I think corporate earnings will, as they should, determine the direction of the market for the coming year.

The next Model Shadow Stock Portfolio update will be in April 2016. Happy new year, and keep up with the Model Portfolios here.