1. AAII Model Shadow Stock Portfolio: Putting Theory Into Practice
Wayne A. Thorp, CFA
Senior Financial Analyst & Vice President, AAII

2. Model Shadow Stock Portfolio
Sound Academic Research
Practical Selection & Trading Rules
The Model Shadow Stock Portfolio developed from an attempt to codify the most persuasive academic theories into a set of practical selection and trading rules that an individual investor could follow with minimal effort
The portfolio has allowed us to share the problems and procedures of managing a portfolio of small stocks using a quantitative approach

3. Presentation Overview
Model Shadow Stock Portfolio Rules
Investment Principles & Objectives
AAII Tools & Resources
The Model Shadow Stock Portfolio developed from an attempt to codify the most persuasive academic theories into a set of practical selection and trading rules that an individual investor could follow with minimal effort
The portfolio has allowed us to share the problems and procedures of managing a portfolio of small stocks using a quantitative approach
Presentation Goals
Walk through the Model Shadow Stock Portfolio rules
Examine investment principles and management objectives behind the portfolio rules
Present AAII tools that can help you build and manage your personal portfolio
AAII Model Portfolio pamphlet included in your tote bag

4. Serial correlation of small-cap returns

5. Primary Size Consideration: Market Capitalization
- Market Capitalization (Market Cap): Price per share times the number of shares outstanding
- Common measure of company size
- Represents public consensus of a company’s net worth

6. Performance by Market Cap
- Market Capitalization (Market Cap): Price per share times the number of shares outstanding
- Common measure of company size
- Represents public consensus of a company’s net worth

7. Invest Where YOU Have the Advantage
- Individuals can take positions in micro-cap stocks without distorting the price
- Individuals can invest in thousands of micro-cap stocks that mutual funds and other institutions cannot touch
- Individuals can time buying and selling to match their tax situation and produce a higher after-tax return

8. Primary Size Consideration: Market Capitalization
Market Cap <= $400 million
Lowest 10% of NYSE-listed stocks
Current cut-off established in September 2016
Original cut-off: $55 million in 1993
Highest cut-off: $400 million since 2016

9. Secondary Size Consideration: Liquidity
Market Cap >= $30 million
Current minimum set in December 2013
Original minimum of $10 million in 1993
No OTC stocks (bulletin board or pink sheets)
Share price >= $4
Use limit orders to control buy/sell prices
Average daily trading volume >= 10x position you are seeking
- Only interested in stocks that have an adequate market for us to take a position
- Avoid stocks in danger of being delisted
- Currently buy stocks with a minimum market cap of $30 million
- Original minimum of $10 million in 1993
- Current minimum of $30 million since December 2013
- No OTC stocks (bulletin board or pink sheets)

10. Primary Value Consideration: Price-to-Book-Value Ratio
- Book Value = Assets – Liabilities
- Also called shareholder’s equity
- Price-to-Book-Value: Relates market’s assessment of company’s net worth to accounting measure of company’s net worth
- Financial structures of all industries not comparable; most studies with book value exclude financial stocks
Shadow Stock Portfolio excludes financial sector
- Book value based on historical accounting measures
- Items of real and substantial value may not appear on the balance sheet (i.e., customer loyalty, copyrights, patents, etc.)
Historical, depreciated value of items carried on book may not reflect the current market value or replacement value
- Price-to-book-value ratio works because, on average over a number of companies and a number of years, accounting book value is a “close-enough” estimate of economic value
- The smaller the market cap, the higher the return

11. Primary Value Consideration: Price-to-Book-Value Ratio
Market Capitalization (Market Cap): Price per share times the number of shares outstanding
Common measure of company size
Represents public consensus of a company’s net worth

12. Primary Value Consideration: Price-to-Book-Value Ratio
Bottom 10% of NYSE stocks
Current maximum set in June 2015
Original cut-off of 0.61 in 1993
Lowest cut-off of 0.60 between August 2001 & October 2003
S&P 500 P/B currently 3.13
Year Ago 2.57 (Barron’s)
- Buy stocks with price-to-book-value ratio in the bottom 10%
- Currently, maximum P/B is 1.0
- Original cut-off of 0.61 in 1993
- Lowest cut-off of 0.60 from August 2000 to October 2003
- Highest cut-off of 1.0 since June 2015
- S&P 500 P/B:
- Currently: 2.69; Year Ago: 2.81
- Rank stocks by P/B, buying those with lowest valuation and adequate liquidity
- Attempt to construct portfolio of stocks that are both lowest 10% in size (market cap) and lowest 10% in value (price-to-book-value ratio)

13. Secondary Value Consideration: Price-to-Sales Ratio
Established a filter in August 1996
Original cut-off of 0.54 in August 1996
Highest cut-off of 1.2 since November 2003
- Current price divided by the sales per share over the most recent 12 months
- Many feel that sales are not as influenced (as earnings or book value might be) by the many management assumptions trickling through the accounting books
- The price-to-sales ratio can provide a meaningful valuation tool when negative earnings render earnings-based models useless
- Stocks and industries with normally high profit margins trade with higher price-to-sales ratios
- Using a static cut-off, such as price-to-sales ratio below 1.2, may always exclude certain industries even if out-of-favor based upon other value measures
Some investors vary price-to-sales ratio cut-offs based upon growth cycle and/or profit margins
- Price-to-sales ratio works as overall predictor of performance, but may overlook high-margin businesses
- Buy: Price-to-sales ratio must be less than 1.2
- Established as a filter on August 1996
- Original cut-off: 0.54 (August 1996)
- Highest cut-off: 1.20 (November 2003 to present)
- “Super Stocks,” by Kenneth L. Fisher, Dow Jones
- Financial Analysts Journal, March/April 1996: “Do Sales-Price and Debt-Equity Explain Stock Returns Better Than Book-Market and Firm Size?”
- “What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time,” by James P. O’Shaughnessy, McGraw-Hill

14. Momentum Consideration: Relative Price Strength
“Growth and value investing are joined at the hip.”—Warren Buffett
“Of all the potential embarrassments to market efficiency, momentum is the primary one.”—Eugene Fama
For value investors, the sweet spot in investing is being able to buy an undervalued stock right before its true value is recognized by the market and just before its stock price begins to take off
We can do this by identifying stocks with good value prospects that are just starting to exhibit good momentum characteristics
Combining value and momentum attempts to help us avoid:
Value traps—stocks whose price continues to fall; these so-called “falling knives”
Trying to avoid stocks whose value will never be recognized by the market
Underperformance due to the opportunity cost associated with holding a stock with great potential, but whose value takes an inordinate amount of time to be recognized by the market
Stocks can stay undervalued (or overvalued) for decades
Using momentum is equally important for what is it eliminating from consideration
It takes buying in a stock based on its undervalued state for it to converge to its intrinsic value
Momentum identifies stocks being bought by investors
It’s often not enough for a stock just to be undervalued, which is why Dr. Cloonan added a momentum filter earlier this year
Notable study from Asness, Moskowitz and Pederson “Value and Momentum Everywhere”
Value and momentum strategies work well together
They found that combining value and momentum strategies resulted in significantly higher risk-adjusted returns

15. Momentum Consideration: Relative Price Strength
Relative Strength 26-week > 50th percentile of stock universe
Added in September 2016
Looking for stocks that rank in the top 50% in terms of 26-week price performance compared to the S&P 500
ONLY used on buy side, not a sell criterion
It is worth noting that by using a relative calculation, we may still be identifying stocks whose price is falling, depending on the overall market direction
This filter identifies stocks who is performing better than half of the stock universe over the last 26 weeks, which may mean their prices have fallen less than the average stock over the last 26 weeks
The benefit of using a relative filter is that we will always have stocks passing the filter, unlike if we were using an absolute level, such as requiring positive price change over the last 26 weeks
We are looking for deep value stocks that are exhibiting above-average price momentum relative to the S&P 500 over the last 26 weeks

16. Levels of Key Factors Over Time
Attempt to construct portfolio of stocks that are both lowest 10% in size and lowest 10% in value as measured by price-to-book-value ratio

17. Shadow Stock Financial Considerations
Adjusted EPS 12m from continuing operations > $0
Not GAAP data; use consensus estimates if available
When available, consensus estimates must also be positive for current quarter and year
Avoid any stock that was sold from the portfolio in the last two years
- Positive earnings from continuing operations over the last quarter and trailing 12 months (last 4 quarters)
- When available, consensus estimates must also be positive for current quarter and year
- Avoid any stock that was sold from the portfolio in the last two years
- Avoid marginal stocks that are forever marginal, creating high transaction costs
- Avoid cyclical stocks going from profits, to losses, to profits, etc.

19. Shadow Stock Financial Considerations
Avoid foreign stocks
Avoid financial stocks, leasing & rental companies, REITs & limited partnerships
Avoid company’s that have not filed a quarterly SEC report (10-Q) in last six months
- Avoid foreign stocks
- Potential for different accounting procedures
- Withholding taxes on dividends
- Avoid financial stocks and limited partnerships
- High levels of acceptable liabilities make it difficult to make meaningful comparisons of popular ratios
- Avoid company’s that have not filed a quarterly SEC report (10-Q) in last six months

20. Building Your Shadow Stock Portfolio: Placing Trades
Average daily trading volume > 10x number of shares you want to buy
You may need to slowly move in & out of positions
Be willing to build positions slowly by placing partial orders
- Exercise care if the average daily volume is not 10x the amount needed for your position
- It will be difficult (costly) to build or sell position
- You may need to slowly move in & out of position
- 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

21. Building Your Shadow Stock Portfolio: Placing Trades
Cancel open orders if price move pushes price/book or market cap beyond buy limits
Keep shares you already have

22. Use Limit Orders for Buy & Sell Trades
Bid/ask spread > 2%: Place limit orders between the bid and ask price to keep the transaction cost low
Bid/ask spread < 2%: Place limit orders at the ask for a buy and at the bid for sell
- Adjust limit price if market is not close to desired price after a few days

23. Use Limit Orders for Buy & Sell Trades
NASDAQ: Use day orders that expire at end of day if not filled
NYSE & Amex: Use good-till-cancelled orders to keep your place in the specialist book
Adjust limit price if market is not close to desired price after a few days

24. Bid-ask spread: (ask – bid) ÷ ask
($ $16.55) ÷ $16.60 = or 0.301%

25. Avg. Daily Volume: 25,398
25,398 ÷ 10 = 2,540 shares maximum supported position
2,540 × $16.80 = $42,672 maximum dollar position

26. Portfolio Construction
Aim for expense ratio under 1.50%
Commissions ÷ total investment
10-stock portfolio minimum number of holdings
$25k minimum investment
15 to 20 stocks: $100k to $1 million
25+ stocks: Over $1 million
Invest equal dollar amounts in each security
10-stock portfolio: minimum number of holdings
15 to 20 stocks: $100,0000 to $1 million
25+ stocks: Over $1 million
Try to invest equal dollar amounts in each security
If building a portfolio slowly by adding stocks over time, try to establish positions that will represent desired portfolio percentage

27. Knowing When to Sell - Sell process just as important as buy process
- Investors tend to sell winning positions too quickly & hold onto losing positions for too long
- Investors hate to give up some of the gain from a winner and would rather lock in a small profit than hold on for larger gain, but risk giving up some of the profit
- Investors like to hold onto losing positions to try and break even
- Rules help to overcome emotions
- Sell when stock no longer attractive and better opportunities are available
- Consider rebalancing when positions put portfolio way out of balance
- Shadow Stock Portfolio sell rules (value & size) normally keep positions from getting too large for very long

28. Rules to Overcome Emotion
Rules help to overcome emotions
Sell when stock is no longer attractive and better opportunities are available
Consider rebalancing when positions put portfolio way out of balance
Shadow Stock Portfolio sell rules (value & size) normally keep positions from getting too large for very long

29. Shadow Stock Portfolio Sell Rules
Price-to-book-value ratio > 3x current buy factor
3 × 1.0 = 3.0
Market cap > 3x current buy factor
3 × $400 mil = $1.2 billion
Adjusted EPS 12m < $0
Stock placed on probation the first quarter trailing EPS goes negative
If subsequent quarter has negative EPS while trailing EPS still also negative, stock is sold
If subsequent quarterly EPS is positive but trailing EPS is negative, stock remains on probation
- Sell: Price-to-book-value ratio goes above 3x the current buy factor (3 × 1.0 = 3.0) & there is a stock to replace it
- Sell: Market cap goes above 3x the current buy factor maximum (3 × $400 mil = $1.2 billion)
- Sell: Negative earnings from continuing operations
- If trailing 12 month EPS from continuing operations turn negative, a stock is placed on probation
- If a subsequent quarter has negative earnings prior to TTM EPS becoming positive, the stock is sold
- Sell: After 2 years of not qualifying as a buy, sell a stock if there is a qualified stock to replace it

30. Shadow Stock Portfolio Management Rules
Decisions are made at the end of the quarter once the earnings results have been announced
Typically in late February, May, August & November
Use best judgment for mergers/tenders, but still follow rules
What if sales proceeds not enough to buy desired number of companies?
Best to focus on transaction cost
Give preference to stocks with lower bid-ask spreads
Invest average portfolio position instead of underweighting

31. Shadow Stock Portfolio Management Rules
Sales proceeds > average position
Invest average portfolio position in qualified stocks
Excess cash held for future purchases
- Decisions are made at the end of the quarter once the earnings results have been announced
- Typically early in February, May, August & November
- Use best judgment for mergers/tenders, but still follow rules
- If proceeds from stocks sold are insufficient to buy all newly qualified stocks:
- Stocks with lower bid-ask spreads are selected, investing average portfolio position

32. Keep a Long-Term Perspective
- Maintain reasonable expectations
- Market is reasonably efficient, but not in the academic sense that all information is instantaneously reflected in prices of all stocks. Nevertheless, information will eventually lead to stock price adjustments
Adjustments quicker for large caps than micro caps
- Micro-cap stocks tend to have consecutive periods of over-performance and then underperformance
- Micro-cap stocks have more volatility than large-cap stocks; important to maintain diversified portfolio and consider all asset classes and foreign markets as well as domestic markets

33. Keys to Shadow Stock Success
Time
Interest
Discipline
Minimize turnover
- To succeed with the Shadow Stock approach:
- Need enough time to manage a stock portfolio
- Approach designed so that it only needs a careful examination quarterly, perhaps an 8-hour commitment
- If one has time, the portfolio can be reviewed monthly to keep up to date on earnings and company news
- Need an interest in managing a portfolio—in good times and bad
- Need discipline to follow the program once you have committed to it
- Important to control turnover with micro-cap stocks

34. AAII Resources

35. Home page for AAII Model Portfolios

36. “Using AAII Portfolios” section has link to PDF version of latest Model Portfolio pamphlet or view as a Web-based guide

37. Home page for AAII Shadow Stock Portfolio

38. “Actual Portfolio” section updated monthly & lists current portfolio holdings
Current price/book, market cap & rel strgth
Special notes (e.g. currently qualifies, earnings probation)

39. Transaction History link leads to a list of Model Shadow Stock Portfolio transactions dating back to 2003

40. Passing Companies section is updated monthly and lists all stocks currently passing initial buy rules
You will need to monitor any stocks purchased from this list since they may not be part of our model portfolio

41. Current Model Shadow Stock Portfolio rules can always be found in this section
Rules are divided into sections dealing with initial buy criteria, sell criteria, guidelines for placing orders, and overall portfolio management rules

42. Past AAII Journal articles dealing with Model Shadow Stock Portfolios are presented in the Commentaries section
Helpful articles to gain an overview of the issues that come up in managing a micro-cap portfolio and how the rules evolve as market conditions change

43. Historical Return link brings up performance chart
Year-to-Year Performance link brings up table of annual performance

44. FAQs (Frequently Asked Questions)

45. Members subscribing to the “AAII Model Portfolio Update” receive a monthly with the latest portfolio changes and current performance

46. AAII Model Portfolio Update

47. Stock Investor Pro
(800)
Systems: Windows Vista, 7, 8 and 10
Price: $198/year (AAII Member); $247/year (Non-Member)
Weekly & Monthly online updates
System used by AAII to build and maintain Shadow Stock Portfolio
Includes Shadow Stock Screen (*IISSP) for performing initial screen
Has screening and analysis tools to monitor portfolio for quantitative sell process

48. Stock Investor Pro
*IISSP (Individual Investor’s Shadow Stock Portfolio) screen is built into Stock Investor Pro
Screen contains Shadow Stock buy criteria
Data as of 2/10/2017
Able to reverse the screen, however, and run it against of portfolio of existing Shadow Stocks to see if any are up for sale

49. Stock Investor Pro

50. Stock Investor Pro
You can also create a sell screen that you can run against a portfolio of Shadow Stocks to see if there are any potential sell candidates
Able to reverse the screen, however, and run it against of portfolio of existing Shadow Stocks to see if any are up for sale

51. Email your comments or questions to wayne@aaii.com
Thank You!
your comments or questions to