Performance of the Model Shadow Stock Portfolio has firmed a bit this past quarter, but year to date it still lags the S&P 500 index as measured by the Vanguard 500 Index fund (VFINX).
The Model Shadow Stock Portfolio has returned 1.2% year to date as of May 31, while the Vanguard 500 Index fund gained 3.2% over the same period.
In general, small stocks are doing better but value stocks are still lagging the market. Overall, the stock market’s performance is below average for the first five months of 2015. This year certainly does not look like the typical pre-election year, but we do have seven months to go.
Over the years, the number of qualifying stocks we encounter in each period has varied considerably. We have had times with zero qualifiers, and in 2008 we reached almost 100 qualifiers. Beyond this volatility, I believe there has been a fundamental shift that will provide fewer qualifying stocks on average under the current rules. This shift may be due to more awareness of the superiority of micro-cap stocks, or it might be a side effect of the larger market value of all stocks.
Our current market capitalization requirement of less than $300 million for purchase puts our stocks in the lowest decile (10%) for market cap as generally measured. While both of the lowest two deciles are considered micro-cap stocks, I believe we should stick with the current requirement because smaller size at this level appears to make more of a difference in results than changes in value (measured by price-to-book-value ratio). In addition, with a maximum of three times the initial criterion, we let stocks run well into the seventh decile for market cap before we sell them.
While the price-to-book ratio is very important, we are at a very low level (a high level of value) compared to most measures of value. In the June 2015 AAII Journal, Charles Rotblut discussed the role of value and its measurement quite extensively (“Using Book Value to Judge a Stock’s Worth”). Most research bases the choice of low or high value on where in the population of price-to-book ratios a stock lies. Is it in the lower half, the lower third, the lower quarter? Based on that, our current rules of a maximum level of 0.80 for purchase would initially put our stocks in approximately the lowest 10%.
The average price-to-book ratio has been increasing in recent years. Based on that, and because I feel comfortable with the notion of stocks selling at book value or less as being bargains per se, I am raising the initial criterion for the price-to-book ratio limit to 1.00. This also means we will not sell a stock because of price-to-book ratio until it exceeds 3.00 (three times the initial criterion), which many analysts would still consider a value stock. This will give us more stocks to choose from and still keep us close to the lower 10% for both market-cap size and price-to-book ratio.
There is one further change having to do with the approach to choosing from among qualifying stocks when the portfolio does not have sufficient funds to buy them all. Since differences between stocks do not seem to be too significant in our range of price-to-book ratio, we will emphasize the transaction costs. Transaction costs are impacted by the width of the bid/ask spread—much narrower being better—but the number of shares at the bid or ask is also important because the spread can widen quickly with large orders. So the lowest transaction cost can be different for different-sized portfolios.
Finally, we will give preference to U.S. stocks. We do this to avoid being in the currency-predicting business. We will continue to buy foreign stocks (except for those based in China), if they are listed on a U.S. exchange and if they otherwise qualify. But, as with illiquid stocks, they will be the last choices.
The current purchase, sale and management rules as well as stock order guidance for the Model Shadow Stock Portfolio can be found here.
The portfolio changes this quarter are based on the new rules.
Four stocks were sold:
(MIND) violated the earnings rule.Proceeds were used to buy positions in three new stocks:
We had some funds left over and bought some additional shares of Salem Communications (SALM) because it currently qualifies and was underweighted in the portfolio.
The stock market continues to stay in a holding pattern close to all-time highs. One gets the feeling that it is ready to move dramatically one way or the other, and analysts seem split in their opinion of which direction it will take. There have been two unexpected major influences: a dramatic drop in oil prices and a quick, extensive rise in the dollar. The various impacts of these occurrences are hard to sort out.
I thought we would see the Federal Reserve enable a small rise in interest rates by fall or maybe even the summer if the employment picture continued to improve. However the International Monetary Fund (IMF) is asking the Fed to postpone interest rate hikes until 2016.
I have the feeling that the next three months will be dramatic, but I am not sure in what way.
The next article on the Model Shadow Stock Portfolio will be in the October issue of the AAII Journal. In the meantime you can follow the portfolio here.
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