January 2014 VOLUME XXXVI, No.

American Association of Individual Investors

2013 AAII STOCK

SCREENS REVIEW:
The Factors Behind the Big Returns

Also Inside:
The Conditions That Have Led
to Small-Cap Outperformance
How Long-Term Care Insurance
Can Protect Your Portfolio
Purchase Guidelines for
Following the Model Shadow
Stock Portfolio
Access All 65 Stock Screens Online
If you haven’t visited AAII.com recently, please take some time today to see what the website offers. Plenty of helpful
resources are available at your fingertips to aid you in the investment process.

This issue of the AAII Journal includes our year-end Figure 1. Stock Screens Performance History Page
stock screening review on page 7. The article offers an in-
depth look at the best-performing screens we track on AAII.
com. In addition, we take a look at certain factors that have
been consistent to winning approaches through the years.
AAII offers all 65 screening methodologies online to
members. Screening methodologies are available across all
different styles and strategies, and there should be at least a
few screens that suit your personal investment beliefs and
risk profile. Each stock screen is accompanied by an overview
explaining the methodology and rationale behind the strategy.
In addition, you can also see the screening criteria used and
a list of passing companies for each month. Though we
originally created these screens as a way to track investment
performance for different strategies across various market
cycles, it can definitely be used as a “watchlist” of stocks.
Annual performance for each of our screens is reported
online in the Performance History tab (Figure 1). In addi-
tion, you can download the monthly performance for our
screens going back to 1998. We also offer a risk and return

Figure 2. Stock Screens Risk & Return Page

spreadsheet with an expanded version that can be downloaded

as an Excel spreadsheet (Figure 2). The risk and return
spreadsheet is very telling, presenting risk-adjusted returns as
well as best- and worst-performing months for each screen.
In addition, the page and downloadable spreadsheet show
bull- and bear-market returns.
If you are interested in stock screens, we encourage
you to read the year-end stock screening review on page
7. Additional resources that can help you get started are
available online for all AAII members at www.aaii.com/
stock-screens. Finally, for investors who want to create their
own screens, perform additional fundamental analysis, and
see weekly instead of monthly lists of passing stocks, AAII
offers Stock Investor Pro, an advanced stock screener and
research database (go to www.aaii.com/stock-investor-pro
for more information).

To log into AAII.com, simply type in your 10-digit AAII member

number (from the mailing label on your AAII Journal) for both Login
Name and Password when prompted. 

January 2014
 JANUARY 2014
Table of Contents Volume XXXVI, Number 1

EDITORIAL STAFF
Vice President, Editor: Charles Rotblut, CFA
AAII Stock Screens Managing Editor: Jean Henrich
2013 Stock Screens Review: The Year of the Bulls ............................. 7 Production Editor: Andrew Lautner
By Joe Lan, CFA Editorial Assistant: Kate Peltz
More than 40 of the 65 screens tracked on AAII.com beat
the S&P 500 last year. Plus, two new risk measures are presented.
Chairman: James B. Cloonan, Ph.D.
Beginning Investor: Determining How Much to Allocate to Each Investment .......... 16 Vice Chairman: John Markese, Ph.D.
By Charles Rotblut, CFA President: John Bajkowski
Senior Financial Analyst: Wayne A. Thorp, CFA
Allocate by the percentage of portfolio dollars, not by the number of shares. Assistant Financial Analyst: Z. Joe Lan, CFA

Stock Strategies EDITORIAL POLICY

Exploiting the Relative Outperformance of Small-Cap Stocks .......... 17
It is not the policy of the AAII Journal to
promote any specific investments or techniques
By John B. Davenport, Ph.D., and M. Fred Meissner
of analysis. The opinions of authors are their
Small-cap stocks outperform large-cap stocks during periods of eco- own and not necessarily those of AAII. It is the
nomic expansion and can deliver excess returns when a sector rotation strategy is used. editorial opinion of the Journal that no one area of
investment is suitable for all investors and that no
single method of evaluating investment opportuni-
Trading Strategies ties has proven to be successful all of the time.
To Trend or Not to Trend .............................................................. 21 AAII is not a registered investment adviser or
By Ray Rondeau a broker/dealer. Readers are advised that articles
Price action is related to and influenced by the technical landscape are provided solely for informational purposes
of the charts, but looking at additional factors, including the fundamentals, can and should not be construed as an offer to sell or
provide added insight. the solicitation of an offer to buy securities. The
opinions and analyses included herein are based
on sources believed to be reliable and written in
Insurance Products and Annuities good faith, but no representation or warranty,
Long-Term Care of Your Personal Finances ................................... 25 expressed or implied, is made as to their accuracy,
By Christine Fahlund, Ph.D., CFP completeness, timeliness, or correctness. Neither
Long-term care covers the costs of assistance with daily living activities we nor our information providers shall be liable
and can protect your financial stability. Pay attention to a policy’s condition triggers for any errors or inaccuracies, regardless of
cause, or the lack of timeliness of, or any delay or
and elimination periods. interruptions in, the transmission thereof to the
users. All investment information contained herein
Insurance Products and Annuities should be independently verified.
Life Insurance Cash Value: A Practical Discussion.......................... 29
Past performance is no guarantee of future
results. Investment information provided may
By Peter Katt
not be appropriate for all investors. Investment
Borrowing against or withdrawing the cash value of a policy will information is provided without consideration of
reduce the death benefit and could put the policy at risk of lapsing. your financial sophistication, financial situation,
investing time horizon, or risk tolerance. Readers
are urged to consult with their own independent
AAII Model Portfolios financial advisers with respect to any investment.
Model Shadow Stock Portfolio: Purchase Guidelines and
Rule Changes ................................................................................ 32 The AAII Journal (ISSN 0192-3315) is pub-
By James B. Cloonan lished monthly by the American Association of
Guidelines regarding price action and news are discussed, as well as Individual Investors. For information or to notify
a higher market capitalization limit and the latest portfolio changes. of a change of address, contact AAII at 625 N.
Michigan Ave., Suite 1900, Chicago, Illinois 60611,
(312) 280-0170, (800) 428-2244, www.aaii.com.
Departments Please use mailing label or member number when
Editor’s Note .........................................2 Briefly Noted..........................................4 corresponding. POSTMASTER: Send address
AAII Investor Surveys .............................3 Letters ...................................................6 changes to AAII, 625 N. Michigan Ave., Suite
1900, Chicago, IL 60611.

Subscription rate: $49.00 per year. Add $15.00 to

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The AAII Journal is a registered trademark of the

American Association of Individual Investors.

© 2014 by the American Association of Individu-

al Investors and its licensors. All Rights Reserved.

Printed in the U.S.A.

 Editor’s
Note
T he first issue of the AAII Journal was published 35
years ago. On the inaugural cover were simply the words:
“The American Association of Individual Investors is an
independent nonprofit corporation formed for the purpose
of assisting individuals in becoming more effective manag-
ers of their own assets through programs of education,
information and research.” (The second issue featured a
photo of the Chicago Board of Trade. In recognition of you have been member for over 30 years or a member for
the Journal’s start, a more current photo appears on this less than a year, we hope you have benefited from all of
month’s cover.) the resources AAII provides, including the AAII Journal. If
Many magazines have come and gone since the first so, please tell a friend or a family member. As a nonprofit
AAII Journal was published. Much of the credit for the organization, we are reliant on membership dues to fund
continuation of this journal goes to AAII founder James operations. Spreading the word about AAII is one of the
Cloonan, who is the first recipient of the Cloonan Award best ways you can help ensure that we will be around for
for Excellence in Investment Education. (More information the decades to come.
about the award can be found on page 4.) My predecessor As an AAII member, you have access to more than
Maria Crawford Scott also deserves much credit for every- 60 stock screens on AAII.com. These screens are based
thing she accomplished during her 25-year tenure as editor. on the methodologies of many famous investors. I’m a big
Much has changed since 1979. As Jason Zweig noted believer in stock screens since they can not only quickly
in a November 2013 Wall Street Journal article about Jim identify stocks with the traits you desire, but often lead you
Cloonan, brokerage commissions have plunged from over to good stocks you would have otherwise not looked at.
$40 to under $10. Most individual investors only have infre- On page 7, you can find updated performance numbers
quent conversations with a representative of their brokerage for all of the screens we track and Joe Lan’s discussion of
firm, and those conversations are typically about something what common traits the best screens share.
other than placing a trade. Defined-contribution plans (e.g., AAII members also have access to the Model Shadow
401(k) plans) have largely replaced defined-benefit plans Stock Portfolio, begun by Jim Cloonan. First discussed
(e.g., pensions) as employer-sponsored retirement plans. in a 1992 AAII Journal article, this portfolio continues to
Exchange-traded funds, which didn’t even exist until 1993, follow the philosophy of seeking undervalued, small-cap
now control over $1.6 trillion in assets. Information is stocks overlooked by most investors and is still managed
distributed faster than ever and investors can access data, by Jim. The latest update to the portfolio—which includes
and instantly react to it, anywhere that Internet connectivity two deletions, one addition and one reinvestment—appears
exists. The Dow Jones industrial average was approximately on page 32.
820 at the start of 1979; as we went to press in late Decem- In addition, this month’s issue features great articles
ber 2013, the Dow was trading at approximately 16,150. about longevity insurance, how small-cap stocks react to
Somet things have not changed. The first feature article economic cycles, trend following and the cash value of
in the AAII Journal discussed how to resolve problems life insurance policies. I hope you find the articles useful
with your brokerage firm. Memories of the last two bear and interesting.
markets were still fresh in 1979, as they are at the start of
2014. Uncertainty about the direction of the economy and Wishing you prosperity,
frustration with the federal government existed then and Charles
unfortunately exists now.
Another thing that has not changed is AAII’s mission. Charles Rotblut, CFA
The words that appeared on the inaugural issue remain our Editor, AAII Journal
mission today. Our goal has always been and continues to be twitter.com/charlesrotblut
to help you become a better and a smarter investor. Whether

2 AAII Journal
 Investor Surveys

AAII Investor Surveys As of December 11, 2013

Sentiment Survey Historical Averages
The sentiment survey measures the percentage of individual investors Bullish: 39.0%
who are bullish, bearish and neutral on the stock market short term;
individuals are polled on the AAII website; the percentages and averages
Neutral: 30.5%
are for all members responding. Bearish: 30.5%

Bullish Sentiment
50
Spread Between Bullish & Bearish Sentiment
40%
40 30%

20%
30 10%

0%

20 -10%

-20%

-30%
10
-40%
Nov-12 Jan-13 Mar-13 May-13 Jul-13 Sep-13 Nov-13
0
41.3% 39.2% 43.2% Blue line = historical average
Most Recent Prior Month Last Year

Asset Allocation Survey Historical Averages

The asset allocation survey measures the percentage holdings of Stocks: 60%
members in five asset categories. Members are polled monthly on
the AAII website; the percentages and averages are for all members Bonds: 16%
responding. Cash: 24%

80

70
18% 60
Cash
3%
Bonds 35% 50
Stock Funds
40
14% 30
Bond Funds
20

30% 10
Stocks Nov-12 Jan-12 Mar-13 May-13 Jul-13 Sep-13 Nov-13

Stocks Bonds Cash

Updated results for both surveys are available by going to www.aaii.com/investorsurveys. The Sentiment Survey is updated
every Thursday morning, while the Asset Allocation survey is updated on the first day of every month. Numbers may not add up
to 100% because of rounding.

January 2014 3
 The Cloonan Award for Excellence in Investment Education
As stated in the Editor’s Note, the very first cover for individual investors to play to their strengths, perform
of the AAII Journal featured a statement that has defined appropriate research, take a long-term perspective and not
AAII’s mission throughout our history. That statement get caught up in the emotions of the market.
was: “The American Association of Individual Investors To honor Jim’s work in the field of investment education
is an independent nonprofit corporation formed for the and research for the individual investor, AAII’s board of
purpose of assisting individuals in becoming effective directors has established the Cloonan Award for Excellence
managers of their own assets through a program of in Investment Education. The award will be presented to
education, information and research.” individuals who have made significant advances and contribu-
James Cloonan founded the American Asso- tions in the area of individual investor education. This past
ciation of Individual Investors in 1978 with the clear November, the board presented Jim with the inaugural award
understanding that individual investors have unique at AAII’s 2013 Investor Conference in Orlando, Florida.
investment needs and opportunities. The investment Congratulations, Jim!
environment was very different when AAII began over
35 years ago. Investment information did not flow easily.
Research involved a trip to the library to study a com-
pany’s “tear sheet” and sending a letter to a company
to request an annual report. Investor education for the
individual investor was very limited. Fixed-brokerage
commissions had just recently been stricken, freeing
“mayday” brokers to compete on price and spurring
the era of active individual investors.
Jim earned an MBA from the University of Chicago
and a Ph.D. from Northwestern University. He was a
business professor and was running an options-broker-
age firm when he realized the need for an organization
that would provide unbiased information, education and
research for the individual investor. Jim continues to
believe that if you take investing seriously, you can do
Photo by Kathleen Muhle
better than professional money managers. It is important

Companies Play Favorites to Hide Bad News

Corporate executives selectively choose which ana- than those who were not allowed to speak.
lysts they interact with during conference calls to avoid Three primary variables played a significant role in
unwanted questions. This “casting” of calls happens determining how casted a conference call was. Companies
when there is potentially bad news a company does not with unusually high levels of accruals were 25% more likely
want highlighted, according to Harvard researchers. to call upon only those analysts issuing the most optimistic
The researchers reviewed more than 69,000 tran- ratings. Companies that either met earnings expectations or
scripts for conference calls held between 2003 and topped earnings estimates by just a penny per share were
2011. On average, 4.26 analysts were allowed to ask 23% more likely to cast their calls. Planned insider selling
questions during a typical quarterly earnings call out of was the third variable. Executives who were intending to
the 11.45 analysts covering a stock. Though brokerage sell their shares were 40% more likely to take questions
ratings tend to be overly positive, the analysts who were only from analysts issuing favorable recommendations.
allowed to speak had more bullish ratings on the stock Two other characteristics were also identified. Com-

4 AAII Journal
 Briefly Noted

The Top Proxy Issues of 2013, and Likely 2014

IR Magazine, which covers investor relations from a control of the board and is viewed as being unfriendly
global perspective, compiled a list of the top trends from to shareholders.
2013’s proxy season and predicted what shareholders and At the same time, proposals to redeem poison pills
corporations could see in 2014. First, the top trends for 2013. and for cumulative voting for directors are down. Poison
Shareholder Engagement: Not only are corporations pill provisions allow companies to alter their capitalization
more willing to engage with shareholders, IR Magazine structure, often by allowing shareholders to buy additional
says institutional investors are becoming overwhelmed with shares, and are intended to thwart hostile takeovers. IR
requests for meetings from the companies they invest in. Magazine says many companies have either proactively
Much of the desired communications surround the topic redeemed these plans or chosen not to renew them.
of executive compensation. Cumulative voting allows shareholders to choose how
Voting Against Directors: Activist investors became they distribute their votes for directors.
more aggressive last year in forcing changes on corporate As far as 2014 is concerned, four key themes could
boards. A total of 19 proxy contests occurred in 2013, emerge. More attention could be paid to how a CEO’s
more than double the number in 2010. Accompanying these compensation compares to that of his company’s average
challenges was an increase in proposals for alternative slates employee. Though companies are not required to disclose
of directors proposed by activist investors. this data until 2016, Bloomberg is beginning to publish
Executive Pay: The number of executive pay proposals the ratios. Demands to allow shareholders to propose
declined to 83 last year from 116 in 2010. The majority of board candidates, subject to ownership requirements,
pay proposals made in 2013 focused on seeking to eliminate could intensify. Shareholder activism may increase, with a
accelerated vesting of options in change-of-control (e.g., a company’s size or stock performance no longer shielding
merger) agreements and equity retention requirements for it from scrutiny. Finally, hedge funds may look to proxy
top executives. fights to push for their interests.
Declassifying Corporate Boards: Ending the practice
of staggering board elections was one of most popular Source: “Proxy Season: What’s Hot, What’s Not,” by Mat-
demands among shareholder activists. Staggering when thew Scott and David Bogoslaw, IR Magazine, December 11,
the term of each board member expires makes it more 2013.
difficult for an activist investor or another party to gain

panies with more analyst coverage and a higher proportion Rather, companies tend to cast conference calls for just
of institutional ownership tended to cast their conference one quarter. This suggests, according to the researchers,
calls significantly less. Conversely, companies with more “that casting is something a wide range of firms engage
volatile stocks were more likely to cast their calls. in selectively at precisely those times they have strong
Being more selective about which analysts can speak incentives to do so, and is not a behavior concentrated
on a conference call gives a company a few advantages. It in a few firms that continuously cast their calls.” Because
prevents executives from being faced with tough questions. the practice is temporary, often the bad news comes out
It reduces the chance of the company’s accounting practices when the next quarter’s earnings are released.
or reported numbers from being publicly scrutinized and
questioned. It also allows for bad news to be downplayed Source: “Playing the Favorites: How Firms Prevent the Revelation
or to be kept out of the public eye. of Bad News,” by Lauren Cohen, Dong Lou and Christopher Mal-
The casting of calls is not a continuous event, however. loy, Harvard Business School Working Paper, September 4, 2013.

January 2014 5
 Letters
The Journal welcomes letters to the editor. We reserve the right to edit. Letters should be addressed to: Editor, AAII Journal, 625 North
Michigan Avenue, Chicago, Illinois 60611. Be sure to include your name and address. Alternatively, emails may be sent to: journal@aaii.com
and comments can be posted online for all articles. Past AAII Journal articles referenced here can be accessed at AAII.com.

Tax Guide Updates I must question the following sentence from the claiming
strategy example: “In Strategy 2, Peggy begins benefits in
Comment posted to “The Individual Investor’s Guide four years, when she turns 62, of $900 a month and Mark
to Personal Tax Planning 2013,” by AAII staff, in the begins spousal benefits only at that time of $450 a month,
December 2013 AAII Journal. half of her primary insurance amount.” I believe Mark’s
In the Estate Tax section, there is a typo saying for $450 should be $600, half of Peggy’s PIA; unreduced
2014 the total effective exclusion would be $10.68 billion; because Mark has attained full retirement age. Correct me
I believe that should be million. if I’m wrong!
—Susan Crabtree from Ohio —Bob G. from Colorado

Charles Rotblut responds: Bill Reichenstein responds:

The estate tax exemption for 2014 is $10.68 million, not You are correct; there is an error in Table 3. Since her PIA
$10.68 billion. We’ve fixed the typo online, and apologize for is $1,200, he should get spousal benefits of $600 from age 66
the error. through age 69, a total of four years. I incorrectly have Mark
getting $450 per month in spousal benefits. Corrections have
On December 6, 2013, the Internal Revenue Service been made to the online version of the table and the article.
(IRS) published the standard mileage rates for 2014. The
deductions are 56 cents per mile for business, 23.5 per mile
for medical or moving purposes and 14 cents per mile for When to Begin Social Security Benefits
charity service. The 2013 Tax Guide has been updated on
AAII.com to reflect these new numbers. Comment posted to “Social Security Strategies for Singles,”
—AAII staff by William Reichenstein and William Meyer, in the No-
vember 2013 AAII Journal.
Take the money as early as possible. If not needed for
Social Security Spousal Benefits current income, invest the money in an adjustable interest
rate mutual fund. At a discount rate of 5%, money today is
Comment posted to “Social Security Strategies for worth far more than inflows beginning five years or more
Couples,” by William Reichenstein and William Meyer, down the road. Plus, if the retiree needs increased savings
in the December 2013 AAII Journal. for long-term care at age 66 or older, he or she will have
My wife and I are pursuing Strategy 2 since I am five ready resources available.
years older and have double the primary insurance amount —Edwin Perkins from California
(much like the example). However, I suggest that everyone
who hasn’t yet committed to a strategy make their own Suppose you have a significant amount of IRA/401(k)
spreadsheet calculator based on the article (good job show- money. If you take Social Security at age 62, maybe you
ing the calculations). You can then set up as many cases as should leave the IRA/401(k) to grow tax-deferred until age
you want. As in all things in life, it all comes down to when 70, versus having to draw upon some of those dollars for
each of you perish. So, while my wife and I are pursuing eight years if you wait until age 70 to take Social Security.
Strategy 2, if we both die at age 85, it would be no different Furthermore, required minimum distributions starting
net present value (if I recall correctly when I did this calcu- at age 70 will push your taxable income higher. You want
lation) than if we both took benefits at full retirement age. to start Social Security at 70, further pushing up taxable
In the end, what I made the decision on was that: 1) income? Anyone else think income tax rates might be higher
we don’t really need Social Security to live a good life, at in eight years?
least until I am 70, and 2) I wanted to leave my wife a good —Anthony Crocker from California
annuity after I die, assuming average life expectancies (when
she is likely to really need it).
—Tim Soles from Texas

6 AAII Journal
 AAII Stock Screens

2013 Stock Screens Review:

The Year of the Bulls
By Joe Lan, CFA

Article Highlights
• AAII’s Stock Screens realized a median return of 29.4% for the year, with 43 out of 65 screens beating the S&P 500.
• The value-oriented Piotroski High F-Score screen remained the best performer, with a 142.3% gain for 2013.
• Two new risk measures are now tracked: the Ulcer Index and the Martin Ratio.

As we approach another calen- once again broken 4,000 (the NASDAQ is

still significantly lower than it was during the
dar year end, I can’t help but reflect
dot-com boom, showing how incredibly rich
on what an incredible year it’s been tech firms were during that time). While I
for the stock market. will not make any specific predictions, it is
Coming into this year, analysts were prudent to keep in mind that our economy
hoping for a positive 2013, but did not re- has been growing with an extended period
ally know what to expect. Unemployment of unprecedented economic stimulus. It
was still stubbornly high and, in addition, will be telling to see how the economy
our economy was facing the possibility of across-the-board responds to the tapering of the bond-buying program and,
tax hikes in conjunction with automatic spending cuts, or eventually, the raising of interest rates. Federal Reserve Chair-
sequestration. If you asked me then what the chances of the man Ben Bernanke has stated that the Fed is not looking to
S&P 500 index gaining more than 25% for the year were, raise interest rates until unemployment drops to 6.5%, but I
I would have said slim to none, leaning more toward none. would be shocked to see the current near-zero interest rate
Now, as I am writing this, the major U.S. market indexes maintained if inflation starts to take off before unemploy-
have all gained more than 25%, and we are merely a few ment hits that level.
weeks away from the end of the 2013 calendar year. The In addition, a quick look at some very simple valuation
market has been in an upward trend for the entire year, with factors provides a small glimpse to the current overall valu-
just some minor pullbacks. Market pullbacks during the year ation of the market. As of the end of November, the stocks
were almost always due to two specific reasons: weakness in in the S&P 500 were trading with a median price-earnings
the global economy, especially from a slowdown in emerg- ratio of 20.7 and a median forward price-earnings ratio of
ing markets; and worries over the potential tapering of U.S. 17.6. Over the past seven years, the average median price-
government stimulus measures. These concerns were at the earnings ratio for the large-cap stocks has been 17.0. The
forefront when the market dipped in mid-May. However, after S&P MidCap 400 index is trading at a median price-earnings
concerns over tapering were alleviated, stocks began rallying ratio of 21.8, with a forward price-earnings ratio of 19.2 as
again. In October, the market took another breather as the of November 30, 2013. Over the last seven years, the average
government “shut down” for 17 days due to our politicians’ median price-earnings ratio of mid-cap companies has been
inability to hammer out a nonpartisan budget deal. However, 18.9. Finally, as of November 30, the median price-earnings
stocks were able to rebound once again shortly after the ratio of the S&P SmallCap 600 index is 23.9, while its me-
crisis was resolved. dian forward price-earnings ratio is 21.3. Over the past seven
Looking forward, one cannot help but wonder what is in years, small-cap stocks have traded with an average median
store. The S&P 500 and Dow Jones industrial average have price-earnings ratio of 20.7. According to these figures, the
both rallied to all-time high levels, while the NASDAQ has current market is trading at a slight premium compared to

January 2014 7
Table 1. Performance of Stock Screens on AAII.com

Average Annual Price Monthly Risk Measures Holdings

Price Gain (%) Gain (%) Variability Risk Risk-Adj Ulcer Martin Turn-
Price Gain (%) Since 3 5 10 Bull Bear Largest Index Return Index Ratio Avg over
Value Screens YTD 2012 2011 Incep Yr Yr Yr Mkt* Mkt* Gain Loss (X) (%) (%) (X) # (%)
Piotroski: High F-Score 142.3 91.7 (36.4) 31.7 47.9 61.9 30.4 984.8 (53.6) 43.1 (42.0) 2.06 18.7 14.9 1.97 22 24
Price-to-Free-Cash-Flow 91.6 1.1 (7.0) 21.1 26.8 48.3 19.2 662.8 (62.8) 51.2 (31.7) 1.78 14.7 16.2 1.15 30 22
Fundamental Rule of Thumb 45.6 (6.9) (35.2) 14.7 (2.0) 17.8 9.5 108.2 (57.0) 33.8 (19.2) 1.70 11.3 19.1 0.64 50 21
Schloss 39.3 13.1 (35.1) 12.9 7.8 13.0 6.1 70.4 (37.6) 27.1 (40.4) 1.86 9.9 21.4 0.49 13 55
Cash Rich Firms 33.5 10.5 (32.8) 11.1 0.4 13.3 5.4 79.0 (45.6) 17.6 (20.7) 1.37 9.8 15.8 0.55 30 25
Graham—Defensive Investor (Non-Utility) 31.8 18.9 7.0 18.2 21.2 30.0 18.2 286.7 (52.1) 25.8 (17.3) 1.37 15.0 12.4 1.27 21 20
Dogs of the Dow: Low Priced 5 30.9 15.7 13.1 2.1 21.9 12.0 0.3 226.2 (82.9) 27.6 (34.8) 1.58 (0.4) 36.7 (0.01) 5 16
O’Shaughnessy: Value 26.6 20.3 (11.2) 6.1 13.2 15.2 4.5 148.4 (69.1) 22.0 (23.8) 1.34 6.0 16.6 0.53 50 21
Dogs of the Dow 25.9 9.6 10.7 2.8 17.3 14.4 2.8 177.3 (69.0) 17.1 (23.4) 1.22 1.9 23.8 0.01 10 7
Magic Formula 24.9 7.9 (30.6) 11.2 2.3 21.8 6.0 156.6 (51.6) 30.7 (22.4) 1.65 9.3 16.6 0.53 30 24
Weiss Blue Chip Div Yield 17.6 19.2 7.6 11.1 17.7 20.3 10.2 174.2 (43.1) 16.0 (16.8) 1.22 10.3 11.9 0.73 12 25
Graham—Defensive Investor (Utility) 10.9 1.2 8.6 7.9 8.0 6.0 7.7 55.3 (31.4) 12.0 (13.4) 0.90 8.0 10.0 0.54 19 13
Graham—Enterprising Investor 10.5 1.1 (1.1) 17.8 3.4 21.8 16.5 159.0 (50.3) 33.1 (23.4) 1.75 13.0 15.8 0.98 4 44
Graham—Enterprising Investor Revised 4.1 (4.9) (4.1) 21.3 (1.7) 28.3 22.9 244.8 (49.9) 36.4 (22.4) 1.74 15.0 14.6 1.29 9 25

Value With Price Momentum Screens

O’Shaughnessy: Tiny Titans 47.9 20.0 (22.9) 25.7 13.9 24.6 11.6 193.5 (67.3) 37.4 (21.0) 1.93 16.4 21.9 1.06 25 42
O’Shaughnessy: Small Cap Growth & Value 44.7 30.3 (0.3) 19.9 27.0 18.6 15.7 175.8 (50.6) 18.5 (18.2) 1.51 15.4 18.0 0.97 25 50
O’Shaughnessy: Growth Market Leaders 41.7 15.8 (1.2) 7.8 19.6 16.0 6.4 124.4 (50.5) 13.6 (18.6) 1.22 7.5 19.9 0.27 10 43
O’Shaughnessy: Growth 40.6 28.8 (7.5) 17.7 21.3 20.8 13.5 197.0 (57.2) 18.6 (17.9) 1.51 13.9 18.5 0.83 50 38
Lakonishok 23.3 7.5 (0.6) 14.6 13.6 23.6 15.7 184.9 (32.5) 16.6 (17.9) 1.20 13.2 10.0 1.21 31 90
O’Shaughnessy: All Cap 14.3 12.4 (5.0) 11.6 11.1 15.3 11.8 114.6 (52.1) 18.4 (21.5) 1.37 10.2 17.7 0.52 22 34

Growth Screens
Dual Cash Flow 43.0 5.1 (21.6) 14.9 7.5 23.1 8.8 178.7 (61.0) 34.7 (23.6) 1.53 12.0 17.2 0.73 68 31
Return on Equity 33.8 10.1 (5.7) 13.6 13.0 22.4 11.4 191.1 (47.2) 14.6 (22.2) 1.28 12.0 11.8 0.95 33 21
IBD Stable 70 33.5 24.6 3.7 11.7 22.3 27.2 9.9 224.9 (50.6) 18.4 (21.9) 1.18 10.9 12.6 0.73 40 12
Inve$tWare Quality Growth 30.4 19.7 (9.4) 7.3 14.8 19.3 7.8 151.4 (44.7) 18.2 (22.0) 1.25 7.1 13.4 0.36 21 11

Growth With Price Momentum Screens

O’Neil’s CAN SLIM Revised 3rd Edition 50.1 7.3 (30.1) 16.7 4.9 13.0 5.3 87.5 (27.8) 52.7 (26.7) 1.86 12.0 15.5 0.92 8 65
Driehaus 38.5 16.7 (14.1) 13.8 13.9 37.4 16.8 386.3 (53.4) 51.3 (25.7) 2.24 9.7 39.7 0.29 15 64
O’Neil’s CAN SLIM No Float 27.7 8.9 (3.9) 16.8 12.5 18.4 7.3 181.9 (61.6) 23.5 (35.5) 1.39 13.9 18.8 0.76 16 50
Foolish Small Cap 8 23.7 16.9 (14.9) 12.1 8.6 18.5 4.2 180.5 (67.7) 38.8 (22.5) 2.23 9.0 25.2 0.38 17 40
Kirkpatrick Growth 19.3 (9.8) (11.6) 16.7 (0.0) 15.6 13.5 103.3 (38.7) 64.1 (23.1) 2.15 11.3 27.7 0.52 12 62
O’Neil’s CAN SLIM 15.3 18.0 (10.2) 24.2 6.9 16.9 15.0 118.0 (10.1) 69.6 (23.1) 1.90 15.8 12.2 1.78 6 57

Growth & Value Screens

Rule #1 Investing 48.6 11.3 (1.0) 12.3 19.2 37.0 10.3 353.5 (54.0) 27.0 (26.8) 1.77 9.8 19.0 0.52 14 25
Wanger (Revised) 46.9 23.5 (5.2) 10.1 22.0 19.8 11.6 168.0 (51.3) 22.8 (19.8) 1.43 9.0 16.4 0.46 31 27
Neff 42.8 15.0 (4.2) 20.0 18.7 31.7 12.7 303.3 (52.8) 32.6 (21.7) 1.63 14.8 15.0 1.17 22 33
Buffettology: EPS Growth 36.7 17.4 3.8 11.5 19.9 26.2 11.4 240.4 (48.4) 15.1 (20.8) 1.22 10.6 11.4 0.79 47 12
Dividend (High Relative Yield) 36.6 9.8 3.0 9.5 18.0 17.1 7.9 145.4 (40.4) 12.5 (14.2) 0.96 9.6 12.3 0.57 40 20
Murphy Technology 36.2 42.3 (29.8) (2.0) 13.1 23.6 11.7 168.8 (58.3) 58.5 (44.9) 2.77 (17.1) 73.8 (0.06) 11 21
Fisher (Philip) 34.3 (0.6) (50.9) 4.0 (12.0) 10.0 (2.6) 49.7 (58.2) 32.8 (27.9) 2.18 1.1 28.5 0.06 20 33
Buffettology: Sustainable Growth 32.7 8.8 0.7 11.9 14.9 24.3 11.6 206.9 (41.9) 16.5 (20.4) 1.28 10.7 10.2 0.92 33 13
Buffett: Hagstrom 32.4 13.0 8.2 15.2 18.9 22.5 13.8 194.9 (39.8) 13.2 (19.0) 1.11 14.3 9.6 1.33 30 20
Price-to-Sales 32.3 11.3 (2.6) 16.2 15.6 23.9 10.7 211.7 (55.1) 18.3 (20.6) 1.32 13.8 13.4 1.03 56 39
Lynch 29.4 0.7 (27.9) 13.0 (0.5) 17.6 12.2 128.1 (47.5) 18.9 (21.3) 1.22 11.8 14.7 0.72 26 21
T. Rowe Price 28.5 (15.0) 117.4 10.4 35.2 32.3 11.5 330.5 (62.5) 33.5 (20.0) 1.68 8.8 23.4 0.34 8 42
Kirkpatrick Value 27.2 19.4 (15.1) 12.3 8.8 (2.4) 15.7 1.1 (23.3) 49.0 (25.3) 2.21 9.1 26.9 0.36 2 74
Dreman 26.2 20.6 (11.7) 11.1 13.2 19.7 8.4 123.2 (55.0) 23.9 (22.2) 1.25 10.2 17.8 0.49 21 32
Templeton 25.9 31.0 3.2 11.0 20.6 27.2 11.3 185.6 (40.0) 14.5 (23.1) 1.23 10.1 13.6 0.63 22 28
Zweig 24.1 6.4 (18.3) 19.7 2.8 4.2 6.6 52.0 (54.4) 32.7 (24.2) 1.79 13.9 25.5 0.68 11 42
Dividend Screen: DRPs 22.9 10.9 1.9 8.8 13.7 18.2 6.4 157.2 (50.4) 20.5 (18.2) 1.10 8.6 15.4 0.41 30 26
Dividend Screen: Non-DRPs 20.4 18.1 4.3 13.2 15.7 18.9 8.9 175.0 (48.1) 17.6 (15.3) 0.91 13.8 12.8 0.84 30 28
Kirkpatrick Bargain 4.8 14.9 3.6 8.3 9.1 10.8 14.9 102.6 (43.2) 21.1 (21.7) 1.37 7.8 16.2 0.36 15 65
Foolish Small Cap 8 Revised 0.4 41.8 (49.2) 15.3 (10.2) 15.5 4.3 105.1 (64.0) 28.1 (31.1) 2.15 10.6 22.7 0.57 6 36

(Continued on next page)

8 AAII Journal
 AAII Stock Screens

Table 1. Performance of Stock Screens on AAII.com (Cont.)

Average Annual Price Monthly Risk Measures Holdings

Price Gain (%) Gain (%) Variability Risk Risk-Adj Ulcer Martin Turn-
Growth & Value With Price Gain (%) Since 3 5 10 Bull Bear Largest Index Return Index Ratio Avg over
Price Momentum Screens YTD 2012 2011 Incep Yr Yr Yr Mkt* Mkt* Gain Loss (X) (%) (%) (X) # (%)
Value on the Move—PEG With Est Growth 52.9 9.0 (0.3) 20.1 20.7 23.2 17.2 210.6 (50.2) 15.7 (23.1) 1.32 16.8 13.7 1.29 41 44
Value on the Move—PEG With Hist Growth 45.8 4.3 1.0 15.0 16.7 21.3 12.3 183.2 (50.1) 12.7 (19.1) 1.04 14.7 13.5 0.93 81 36
Oberweis Octagon 40.6 32.6 (14.7) 14.8 20.4 23.1 12.3 244.0 (70.6) 24.6 (23.2) 1.92 10.8 26.9 0.46 16 42
ADR Screen 32.2 1.4 (25.9) 8.0 2.3 14.3 6.4 105.1 (68.7) 31.1 (29.7) 1.47 7.5 27.4 0.20 25 44
Stock Market Winners 29.4 13.6 21.2 21.0 22.0 29.5 13.1 354.6 (51.3) 22.0 (23.4) 1.47 16.4 17.0 1.09 12 59
MAGNET Complex 20.3 (19.6) 6.9 12.5 4.1 (10.7) (4.7) (30.4) (55.9) 63.0 (28.2) 2.72 8.7 42.1 0.24 2 74
Muhlenkamp (11.6) (3.0) (45.9) 4.1 (21.1) (5.7) (3.4) (20.7) (49.0) 21.0 (17.6) 1.40 3.1 26.1 0.06 18 24
MAGNET Simple (31.1) (12.4) 19.5 17.7 (7.5) 37.2 15.7 339.7 (75.9) 52.1 (34.0) 2.99 10.2 27.2 0.56 3 68

Earnings Estimates Screens

Est Rev: Top 30 Up 35.3 21.9 (2.3) 26.4 20.7 40.9 25.2 366.7 (37.8) 36.4 (26.7) 1.83 17.4 20.3 1.18 30 93
P/E Relative 28.2 14.3 (1.9) 17.0 15.2 26.1 16.5 177.7 (27.6) 18.4 (18.3) 1.13 15.8 8.0 1.82 32 77
Dreman With Est Revisions 27.2 13.0 21.6 16.3 22.7 29.2 17.6 231.7 (39.9) 21.4 (26.2) 1.36 13.7 15.0 0.92 13 83
Est Rev: Up 5% 25.3 28.8 6.1 28.6 22.6 36.7 25.9 299.1 (23.4) 30.8 (21.7) 1.75 19.1 15.7 1.66 42 92
Est Rev: Down 5% 25.0 9.2 (31.1) 1.0 2.4 18.4 2.3 145.2 (63.8) 33.5 (30.5) 1.95 (4.2) 32.9 (0.04) 76 89
Est Rev: Lowest 30 Down 24.8 9.3 (34.1) 0.9 2.4 22.3 1.6 182.5 (71.0) 43.0 (29.9) 2.33 (6.4) 34.3 (0.04) 30 91

Specialty Screens
Insider Net Purchases 8.8 11.5 (31.4) (0.9) (3.1) 7.7 (2.7) 75.5 (65.5) 27.8 (27.2) 1.81 (7.0) 36.0 (0.09) 28 30

Average Annual Price Monthly Risk Measures

Price Gain (%) Gain (%) Variability Risk Risk-Adj Ulcer Martin
Price Gain (%) Since 3 5 10 Bull Bear Largest Index Return Index Ratio
Indexes YTD 2012 2011 Incep Yr Yr Yr Mkt* Mkt* Gain Loss (X) (%) (%) (X)
S&P 500 25.5 13.4 (0.0) 3.9 14.9 14.8 5.4 124.3 (52.6) 10.8 (16.8) 1.00 3.9 22.1 0.07
S&P 500 Growth (w/divs) 32.0 14.6 4.7 5.8 17.7 18.9 7.8 150.1 (44.4) 10.8 (16.5) 1.10 5.6 31.7 0.11
S&P 500 Value (w/divs) 30.6 17.7 (0.5) 5.6 17.8 16.3 7.8 151.1 (56.0) 11.3 (17.1) 1.00 5.6 17.5 0.18
S&P MidCap 400 29.1 16.1 (3.1) 9.0 15.6 20.7 8.8 169.3 (50.5) 14.8 (21.8) 1.20 8.2 13.6 0.48
S&P MidCap 400 Growth (w/divs) 28.5 15.8 (0.9) 12.2 20.8 25.0 11.3 206.2 (47.7) 19.0 (22.2) 1.31 10.3 13.9 0.70
S&P MidCap 400 Value (w/divs) 30.5 20.1 (2.4) 8.7 18.0 21.4 10.2 185.7 (49.4) 15.7 (21.8) 1.11 8.2 13.2 0.47
S&P SmallCap 600 39.1 14.8 (0.2) 8.5 19.7 21.2 9.6 198.0 (52.2) 17.3 (20.2) 1.27 7.5 15.0 0.40
S&P SmallCap 600 Growth (w/divs) 40.7 14.9 4.1 10.0 21.4 24.3 11.6 231.0 (51.1) 17.0 (21.7) 1.31 8.6 13.9 0.54
S&P SmallCap 600 Value (w/divs) 33.5 17.8 (1.2) 8.9 19.1 20.1 9.8 187.8 (51.0) 18.4 (19.6) 1.22 8.0 15.2 0.42
Dow Jones 30 23.0 7.3 5.5 4.6 13.6 12.8 5.1 111.9 (49.3) 11.8 (15.1) 0.97 4.6 16.0 0.13
NASDAQ 100 32.7 16.8 2.7 8.3 18.6 24.4 9.5 152.3 (50.1) 25.0 (27.5) 1.81 6.4 54.0 0.11
All Exchange-Listed Stocks 34.3 14.8 (12.3) 10.8 13.3 24.0 8.5 196.9 (58.6) 23.9 (22.1) 1.38 8.9 16.8 0.50

Bull market period is March 1, 2009, through November 30, 2013. Bear market period is November 1, 2007, through February 28, 2009.
Unless otherwise stated, figures do not include dividends or transaction costs.
Source: AAII's Stock Investor Pro/Thomson Reuters. Data as of November 30, 2013.

See the AAII Stock Screens area on AAII.com for details on each approach.

its seven-year historical averages. of November. The stock screens also into the software (the exceptions are
returned a median of 29.4% year-to- the Dogs of the Dow and Dogs of the
The Rankings date. In addition, three of our stock Dow—Low-Priced 5 screens).
screens managed to have their best Table 1 also presents the price
With the market so strong, it is no years ever—Piotroski: High F-Score, change performance (excluding divi-
surprise that AAII’s stock screens have O’Shaughnessy: Growth Market Lead- dends and transactions costs, time and
also fared extremely well. In fact, out of ers and Dividend—High Relative Yield. price slippage, etc.) over various time
the 65 stock screens that AAII tracks, Table 1 provides summary perfor- periods for each stock selection strategy.
only two screens had a losing year—the mance and volatility statistics for the The screens are grouped by style to
MAGNET Simple and Muhlenkamp stock screens we track on AAII.com. All identify their underlying premise. These
screens. Conversely, 43 out of the 65 of these screens have been created using style groups are: value, value with price
stock screens outperformed the 25.5% AAII’s fundamental stock screening and momentum, growth, growth with price
return that the S&P 500 index was able research database program, Stock Inves- momentum, growth and value, growth
to achieve for the year as of the end tor Pro, and most of them are pre-built and value with price momentum, earn-

January 2014 9
What It Takes: The Investment Characteristics of the 2013 Winners
Table 2 presents the characteristics of the top- and • S&P 500 index, $16.2 billion;
bottom-performing screening strategies for 2013, as well as • S&P MidCap 400 index, $3.6 billion; and
the top and bottom performers based on risk-adjusted return. • S&P SmallCap 600 index: $1.1 billion.
This year was an even better year than the last, with all In a year when smaller caps fared much better than
but two of AAII’s screens in positive territory as of the end larger-cap stocks, all five of the top-performing screens
of November, with a median gain of 29.4%. By comparison, fall into the small- and mid-cap category, with the Piotroski
the S&P 500 large-cap index is up 25.5%. screen having the smallest median market capitalization
of $865.7 million. However, smaller-cap stocks were not
Market Capitalization completely immune and tend to have higher volatility as
The median market capitalization (share price times evidenced by smaller-cap screens dominating the bottom-
number of shares outstanding) of the stocks that make up performing screens for 2013 as well.
the major S&P indexes are:

Table 2. Characteristics of Winning and Losing Stock Screens

Price-
to- P/E to 5-Yr
Price Book- EPS Hist 52-Wk
Change (%) P/E Value Div Grth EPS Market Rel
Ann’l Ratio Ratio Yield (PEG) Grth Cap Str
YTD Risk-Adj (X) (X) (%) (%) (%) ($ Mil) (%)
Top Performers: 2013
Piotroski: High F-Score (Value) 142.3 18.7 14.3 0.84 0.9 0.6 12.4 865.7 (10)
Price-to-Free-Cash-Flow (Value) 91.6 14.7 19.8 2.27 0.0 1.6 7.3 1,880.3 0
Value on Move--PEG W/Est Gr (Gr & Val w/ Price Mom) 52.9 16.8 16.4 7.30 1.5 0.7 24.5 3,702.5 38
O’Neil’s CAN SLIM Revised 3rd Ed (Gr w/Price Mom) 50.1 12.0 21.0 5.30 0.0 1.3 19.4 4,831.1 55
Rule #1 Investing (Growth & Value) 48.6 9.8 13.5 8.90 2.1 0.3 44.0 3,525.2 22
Bottom Performers: 2013
MAGNET Simple (Gr & Val w/Price Mom) (31.1) 10.2 No companies are currently passing the screen
Muhlenkamp (Gr & Val w/Price Mom) (11.6) 3.1 9.7 2.60 0.0 0.4 31.1 888.4 (3)
Foolish Small Cap 8 Revised 0.4 10.6 No companies are currently passing the screen
Graham--Enterprising Investor Revised (Value) 4.1 15.0 9.4 1.00 1.8 0.9 8.2 585.8 (15)
Kirkpatrick Bargin (Growth & Value) 4.8 7.8 21.4 2.40 0.5 1.5 (13.2) 1,978.9 59
Top Performers: Total History, Risk-Adjusted
Est Rev: Up 5% (Earnings Estimates) 25.3 19.1 31.6 3.16 0.0 1.2 13.2 1,395.5 32
Piotroski: High F-Score (Value) 142.3 18.7 14.3 0.84 0.9 0.6 12.4 865.7 (10)
Est Rev: Top 30 Up (Earnings Estimates) 35.3 17.4 32.0 3.10 0.0 1.6 13.2 1,318.2 26
Value on Move—PEG W/Est Gr (Gr & Val w/ Price Mom) 52.9 16.8 16.4 7.30 1.5 0.7 24.5 3,702.5 38
Stock Market Winners (Gr & Val w/ Price Mom) 29.4 16.4 11.4 1.30 0.0 0.5 22.5 84.0 33
Bottom Perfomers: Total History, Risk-Adjusted
Murphy Technology (Growth & Value) 36.2 (17.1) 5.0 1.30 1.9 0.2 43.0 1,281.4 (24)
Insider Net Purchases (Specialty) 8.8 (7.0) 18.6 2.40 0.0 1.6 5.3 244.4 (22)
Est Rev: Lowest 30 Down (Earnings Estimates) 24.8 (6.4) 41.7 2.38 0.0 1.5 (3.4) 775.6 (19)
Est Rev: Down 5% (Earnings Estimates) 25.0 (4.2) 20.4 1.90 0.0 1.2 6.8 901.3 (12)
Dogs of the Dow: Low Priced 5 (Value) 30.9 (0.4) 25.0 2.18 3.8 1.1 6.1 142,000.1 12
All Exchange-Listed Stocks 34.3 8.9 20.6 2.00 0.0 1.5 3.9 807.7 26

Performance figures do not include dividends or transaction costs.

Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of November 30, 2013.

10 AAII Journal
 AAII Stock Screens

Multiples indicate underperformance relative to the index.

Looking at the price-earnings ratios (price divided by The Piotroski screen’s negative 52-week relative
trailing 12-month earnings per share) for the stocks currently strength may seem anomalous at first, but it makes perfect
passing the top-performing screens for 2013, the Piotroski: sense. Piotroski’s methodology seeks out undervalued
High F-Score stocks have a median price-earnings ratio companies that have strong financial strength. For stocks
of 14.3, significantly lower than the 20.6 median value for to be undervalued, they generally fare worse than the
all exchange-listed stocks currently in the Stock Investor Pro overall market, leading to their valuation. The Piotroski
database. In fact, four of the five top-performing screens screen seeks to find these companies that are trading near
have median price-earnings ratios lower than the median for their bottom. Alternatively, O’Neil’s CAN SLIM approach
all exchange-traded stocks. O’Neil’s CANSLIM approach, relies on growth and price momentum. Hence, it has one
a growth methodology, is the only top-performing screen of the highest 52-week relative strength figures of the
with a median price-earnings ratio slightly above that of the screens listed in this table.
exchange-traded stocks in the database.
Looking at the valuations of 2013’s worst-performing Winning Characteristics
strategies, we find a lot of mixed results. In fact, two of When looking at those strategies that have achieved
the worse-performing screens—Muhlenkamp and Graham long-term success, several common factors are apparent:
Enterprising Investor Revised—have very low median price- • Low multiples (price-earnings, price-to-book-value,
earnings ratios. This highlights the fact that low valuation etc.), on a relative rather than an absolute basis;
stocks do not necessarily warrant buys. Often, stocks are • An emphasis on consistency of growth in earnings,
trading at extremely low valuations because there is little to sales, or dividends;
no growth potential whatsoever for the company. • Strong financials;
• Price momentum; and
Relative Strength • Upward earnings revisions.
The relative strength figure (last column) in Table 2 is For a more in-depth discussion of the characteristics
calculated against the performance of the iShares Core S&P of successful investment strategies, see the article “Con-
500 ETF (IVV), which is used as a proxy for the S&P 500 structing Winning Stock Screens,” found on AAII.com
index. Stocks with performance equal to that of the S&P on the right side of the Stocks Screens page in the Site
500 over the last 52 weeks have a relative strength of 0%. Highlights box (www.aaii.com/stock-screens/construct-
A relative strength value of 13% indicates that the stock ingwinningstockscreen).
outperformed the S&P 500 by 13%. Negative numbers —Joe Lan, CFA

ings estimates and specialty. However, these performance num- of the end of November. The gain, if
The AAII stock screens are ranked bers do not include dividend payments maintained in December, would be the
in Table 1 in descending order by their or dividend reinvestment. Therefore, highest for any one year since we started
year-to-date price performance through the results for large-cap strategies, such tracking the screen, which is really excep-
November 30, 2013, within each of their as the Dogs of the Dow (in the value tional as it historically has been one of
style groups. At the bottom of the table, category), do not benefit from dividend AAII’s best-performing screens. In fact,
you will also find performance data for payments or reinvestment. barring some catastrophic meltdown by
several market indexes and averages. Currently, the 10 stocks that make the Piotroski screen during December,
up the Dogs of the Dow have a dividend this year will mark the fifth year since
Impact of Dividends yield of 3.5%; investors holding shares 1998 that the screen has managed to
in these stocks would, therefore, have a gain over 75%.
The Price Gain and Average An- higher annual return by approximately The Piotroski screen is based on
nual Price Gain columns in Table 1 this amount. research by Joseph Piotroski, an ac-
represents the annualized percentage counting professor at Stanford Uni-
gain or loss realized by a hypothetical The Top Performer for 2013 versity Graduate School of Business.
portfolio invested in the stocks pass- During his time as a professor of the
ing a given screen over varying time Following a strong 2012, the Pi- University of Chicago Booth School
periods from January 1, 1998, through otroski: High F-Score screen managed of Business, he undertook a study of
November 30, 2013. to gain an incredible 142.3% in 2013, as low price-to-book-value stocks to see if

January 2014 11
 Behind the Scenes of the Top 2013 Strategy
(continued from page 27)

The Piotroski: High F-Score screen once again turned data and examine the individual stocks that contributed
in a dominating performance in 2013 with a 142.3% price to the overall return.
gain year-to-date through the end of November, its best During the economic downtown, many of the top-
year yet. In a year where the vast majority of AAII stock performing screens did not show any stocks passing their
screens generated positive gains, no other approach came criteria during several months, leading to a 0% return
close. However, when evaluating the performance of a given for the month, which was better than most screens were
approach, it is useful to look beyond the simple gain/loss doing. This year, with the bull market in full swing, the

Table 3. Stocks Passing the Piotroski High F-Score Screen During 2013

Price
Gain Mos Price- P/E to 5-Yr
While in to- EPS Hist 52-Wk
in Port P/E Book Div Est EPS Market Rel
Port During Ratio Ratio Yield Grth Grth Cap Strgth
Company (Ticker) (%) 2013 (X) (X) (%) (%) (%) ($ Mil) (%)
Point.360 (PTSX) 133.8 2 na 0.88 0.0 na (5.9) 8.1 (26)
Cache, Inc. (CACH) 76.2 1 na 3.82 0.0 na (33.1) 130.6 116
Renewable Energy Group (REGI) 67.8 4 6.8 0.81 0.0 na 16.6 365.5 77
Global-Tech Advanced Innov. (GAI) 63.1 7 na 0.27 0.0 na 16.0 21.7 (2)
P & F Industries, Inc. (PFIN) 43.5 3 5.4 0.76 0.0 0.3 18.3 28.1 0
Covenant Transportation Gp (CVTI) 31.1 2 29.7 1.04 0.0 1.6 18.6 97.1 13
Revett Minerals, Inc. (RVM) 30.3 1 na 0.27 0.0 na 14.9 22.4 (86)
SkyWest, Inc. (SKYW) 20.7 9 13.4 0.55 1.1 na (17.0) 782.5 10
Leading Brands, Inc. (LBIX) 17.2 1 20.9 0.97 0.0 1.3 16.3 12.3 (21)
Delta Apparel, Inc. (DLA) 14.1 1 17.3 1.08 0.0 0.2 83.3 147.6 (0)
Fortune Brands Home & Sec (FBHS) 13.0 1 39.9 2.90 0.9 na na 7,151.6 21
Griffon Corporation (GFF) 12.0 1 104.4 1.08 0.8 na (19.2) 747.4 (1)
NASDAQ OMX Group (NDAQ) 9.4 3 18.5 0.98 1.5 na (14.1) 5,928.6 19
Natural Grocers by Vit Ctg (NGVC) 8.4 2 20.8 10.96 0.0 na na 895.1 58
Benchmark Electronics (BHE) 8.2 2 20.3 1.05 0.0 na (4.6) 1,235.0 23
Seacor Holdings, Inc. (CKH) 4.2 2 80.2 1.43 0.0 na (30.0) 1,988.5 15
Fresh Del Monte Produce (FDP) 3.8 8 13.9 0.80 1.9 na (4.3) 1,492.1 (15)
CRA International, Inc. (CRAI) (2.0) 2 na 0.89 0.0 na (61.5) 193.6 (9)
Golden Star Resources (GSS) (18.2) 3 na 0.58 0.0 na 16.7 128.6 (81)

Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of November 30, 2013.

it was possible to establish some basic most of the low price-to-book stocks are easy to use and interpret. In order
financial criteria to help separate the were neglected firms or financially trou- to pass the Piotroski: High F-Score
winners from the losers. bled firms. He found that either situation screen, a stock must pass eight of the
The AAII Piotroski screen starts can create buying opportunities—after nine financial tests.
with stocks that have price-to-book- checking on financial strength—espe-
value ratios ranking in the lowest 20% cially when studying smaller-cap stocks. Performance Over Time
of the entire Stock Investor Pro database. Piotroski developed a nine-point
There are many studies indicating that scale to identify stocks with solid and AAII’s stock screens have a history
a portfolio of low price-to-book-value improving financials. Profitability, fi- going back almost 15 years now, and the
stocks generally outperforms portfolios nancial leverage, liquidity and operating amount of performance data that we
of stocks trading with high price-to- efficiency are examined using popular have collected over these years offers
book-value ratios. Piotroski found that ratios and basic financial elements that some compelling insights. While the

12 AAII Journal
 AAII Stock Screens

Piotroski: High F-Score screen was fully invested throughout number of months the stock was held this year, and select
2013, meaning that at least one stock passed the screen current financial data.
each month. However, Piotroski has been a very strict Point.360 (PTSX) was the best-performing stock that
screen in recent years, so that each individual passing stock passed the Piotroski screen in 2013, though it only passed
has had a large weight in the overall performance of the the screen in two months—April and September. The
screen. In a year where smaller-cap stocks dominated, stock gained 42.5% during the month of April and 64.1%
the Piotroski: High F-Score screen benefited from its tilt during the month of September for a total price-change
toward small stocks. performance of 133.8%. Point.360 is an integrated media
The Piotroski: High F-Score screen starts by isolating management services company providing film, video and
stocks with price-to-book-value ratios that rank in the lowest audio post-production, archival, duplication, computer
20% of the entire stock universe. Then, using a nine-point graphics and data distribution services to motion picture
scale to identify stocks with solid and improving financials, studios, television networks, independent production com-
passing companies must satisfy at least eight of the nine panies and multinational companies. The company provides
tests. Prior to 2011, we had required passing companies to the services necessary to edit, master, reformat and archive
satisfy all nine financial strength tests, but we found that its clients’ audio, video, and film content, which includes
this severely limited the number of passing companies. television programming, feature films, and movie trailers.
Relaxing the screening requirements led to more passing It derives revenues primarily from the entertainment indus-
companies without hurting performance too severely. try, consisting of major and independent motion picture
As a result of the relaxed standards, the Piotroski: High and television studios, cable television program suppliers,
F-Score screen held a total of 19 stocks throughout 2013, television program syndicators, and advertising agencies.
averaging nearly five holdings per month. Historically, the Point.360 also maintains video and audio post-production
strategy has averaged 22 stocks per month, which is right and editing facilities.
at the median for all stock screens. When following a given Two of the stocks held in the Piotroski: High F-Score
strategy, spreading your investment to more stocks will portfolio during 2013 suffered losses, with CRA Interna-
lower your volatility, while investing in a small number of tional Inc. (CRAI) losing 2.0% and Golden Star Resources
companies makes a portfolio more susceptible to individual Ltd. (GSS) down 18.2%. CRA passed the screen for two
stock price movements. The 10 AAII stocks screens that months while GSS passed the screen for a three-month
average the lowest number of passing companies each period.
month are at least 50% more volatile than the S&P 500 The 2013 results for the Piotroski: High F-Score screen
index. That is not to say that the Piotroski: High F-Score build on its historical record of strong performance. Its
screen isn’t volatile. With a risk index of 2.06, the screen annual average price gain of 31.7% since the beginning of
is 106% more volatile than the S&P 500, making it the 1998 allowed the screen to overtake Estimate Revisions
11th most volatile screen. But looking at its historical per- Up 5% this year as the strongest stock screen that AAII
formance, much of that volatility has been to the upside. tracks. No matter which risk-adjusted return measure you
Table 3 presents the 19 stocks that passed the Piotroski: look at, the Piotroski High F-Score and Estimate Revisions
High F-Score screen in 2013, as well as their performance Up 5% are generally always the top two screens.
while they were held in the hypothetical portfolio, the

best-performing screens since inception the Estimate Revisions Up screens. As its long-term returns through much
remain the Piotroski and the Estimate the market continued rallying in 2012 better protection on the downside. The
Revisions Up (Est Rev Up) screens, each and 2013, the Piotroski Screen gained screen looks for upward revisions in
screen takes its place at the top through 91.7% and 142.3% (so far), respec- annual earnings estimates; specifically,
very distinct methodologies and with tively, and is now, convincingly, AAII’s it identifies companies that have had
very different returns through various top-performing screen since inception. at least a 5% increase in annual earn-
time periods. However, the screen has a bear market ings estimates over the last month. The
The Piotroski: High F-Score screen return of –53.6%, with –42.0% as its Estimate Revisions Up 5% screen, with
is a pure value screen and does in- worse monthly return and a maximum an annualized return since inception
credibly well through bull markets. drawdown of 59.0%. of 28.6%, has a bull-market return of
In fact, prior to 2011, the Piotroski Alternatively, the Estimate Revisions “only” 299.1%, which is actually lower
Screen’s performance trailed that of Up 5% screen has managed to achieve than that of the Estimate Revisions Top

January 2014 13
30 Up screen. However, the screen has Currently, the number of stocks passing standard deviation of an index—in this
a bear-market return of –23.4%, with the screen is below-average once again, case, the S&P 500. In essence, the risk
a largest monthly loss of 21.7% and a but only slightly, showing that the market index quantifies how volatile on a price
maximum drawdown of 46.9%. is slightly rich compared to historical return basis a screen is compared to the
Interestingly, two of AAII’s worst- averages based on this valuation factor. S&P 500: A risk index of 2.00 means
performing screens are Estimate Revi- The rightmost column in Table 1 that the screen is twice as volatile as
sions Lowest 30 Down and Estimate shows the average monthly turnover the S&P 500.
Revisions Down 5%, giving credence percentage for each of the screens. The Almost all of AAII’s screens have
to the belief that earnings estimates Estimate Revisions screens have some risk indexes above 1.00, which is to be
play a huge factor in the short-term of the highest monthly turnovers of expected. Stock screens, after all, typi-
performance of stocks. As of the end any of the screens that AAII tracks. cally pass anywhere from a handful of
of November, these two screens have From a conceptual standpoint, this stocks to around 50, while the S&P 500
basically been flat since 1998. characteristic for these screens makes is made up of 500 very heavily traded
perfect sense. As I stated, the Estimate companies. In fact, as of the end of
Average Holdings and Turnover Revisions screens looks for companies November, only three screens have a risk
that have had upward or downward index lower than 1.00: Graham Defen-
Stock screens are often used by earnings revisions over the past month. sive Investor—Utility, Dividend—High
investors as a method to winnow down Not many companies will continuously Relative Yield and Dividend Screen:
a universe of stocks into a more man- pass this screen since that would suggest Non-DRPs. These three screens are all
ageable number. For stock screens to be that analysts are continuously revising made up of “safer” stocks, with two
useful, there should ideally be enough the estimates of a specific company up- dividend screens and a screen that fo-
stocks passing to provide various alter- ward or downward month after month. cuses on utility stocks. On the opposite
natives, but not too many that investors Also, keep in mind that as a general end of the spectrum, we have several
are bogged down with options. rule, value screens tend to have lower screens with risk indexes above 2.00. Our
The right-most columns of Table 1 turnover and growth screens tend to top performer for 2013, the Piotroski
present the average number of passing have higher turnover. screen, has a risk index of 2.06, mean-
stocks and the turnover percentage for AAII’s Piotroski screen has an aver- ing that it is 2.06 times as price-volatile
each of our stock screens. For many age monthly turnover of 24% since the as the S&P 500.
of the screens, you will notice patterns beginning of 1998, meaning that a little
depending on the market cycle. For ex- under a quarter of any month’s passing Risk-Adjusted Return
ample, the Price-to-Sales screen (in the stocks should be expected to be new
growth & value category), which looks (around three quarters of the stocks Table 1 also presents the risk-
for undervalued companies on a price- will remain the same). The screen with adjusted return for each of the screens.
to-sales basis showing strong growth the lowest turnover is the Dogs of the This calculation is a bit more convoluted,
and price strength, passes 56 stocks Dow screen, with an average monthly but essentially it adjusts the performance
per month on average. However, at the turnover of 7%, while the Estimate Revi- of each screen using their standard de-
beginning of 2006 through October of sions Top 30 Up screen has the highest viations of returns, penalizing screens
2007, during the peak of the market average monthly turnover of 93%. The with higher standard deviations. Using
before the great recession, the screen median average monthly turnover for risk-adjusted returns, we still find the
only passed more than 50 stocks in one AAII’s screens is 34%. usual suspects at the top. However, the
single month and often only passed Estimate Revisions Up 5% screen is now
around 30 stocks. Using this screen as Volatility at the top, with a risk-adjusted return of
a gauge pointed to the possibility that 19.1% since inception, and the Piotroski
the market was overvalued during that Most investors look closely at the High F-Score screen is second with a
period compared to historical averages. performance of a screen when choosing risk-adjusted return of 18.7%.
Moving forward, an increasing number an investment methodology. Perhaps Ranking the 65 stock screens ac-
of companies passed the price-to-sales just as important, however, is a compari- cording to risk index, we see that the
screen until the number peaked from son of the overall risk, or volatility, of Graham Defensive Investor—Utility
April of 2009 through March of 2010 the screens. In Table 1, the risk index is screen has the lowest risk index, 0.90.
with 11 straight months where more presented for each of our screens (this Since its risk index is lower than 1.00, it is
than 90 companies passed the screen figure is also available on AAII.com and less price-volatile than the S&P 500. This
per month. As the market continued updated on a monthly basis). means that the screen’s risk-adjusted re-
to recover, the number of passing The risk index is calculated by turn was actually adjusted upward, going
companies for the price-to-sales screen dividing a screen’s monthly standard from a return of 7.9% since 1998 to a
once again fell back to normal ranges. deviation since inception by the monthly risk-adjusted return of 8.0%.

14 AAII Journal
 AAII Stock Screens

Graham’s philosophy divides inves- enues and margins; for their upside volatility, only adjusting
tors into two groups by the amount of G—Growth rate must exceed valu- returns for downside risk. Using this
time they are able to devote to research- ation; metric, the Piotroski Screen still has the
ing and managing a stock portfolio as N—New product or management best overall performance, with the P/E
well as by their level of market experi- may be the driver; Relative screen second. While the P/E
ence. For the defensive or passive inves- E—Emerging industry or product Relative screen returned “only” 17.0%
tor, his analysis is geared toward avoiding creates opportunity; and on an annualized basis since 1998, its
serious mistakes or losses. Graham tries T—Timing needs to be right (techni- Ulcer Index is a mere 8.0, allowing it
to establish a procedure that provides cally poised for large price increase). to jump various other methodologies
freedom from great effort and frequent in terms of risk-adjusted performance
decision-making. Graham feels that the Ulcer Index using the Martin ratio.
defensive investor should confine his or
her holdings to the shares of important Two other measures of risk and Conclusion
companies with a long record of prof- risk-adjusted return are also presented in
itable operations and strong financial Table 1. The Ulcer Index is a measure of AAII’s stock screens have per-
condition. By “important,” he means downside volatility; it was named as such formed very well over the years, and
a company of substantial size with a because downside volatility causes stress 2013 was no exception. When choosing
leading position in the industry, ranking and stomach ulcers. Needless to say, a a stock screen, it is important to under-
among the first quarter or first third in lower number is better, meaning that stand your personal investment profile
size within its industry group. there is less volatility on the downside. before deciding on a screening method-
AAII’s Graham Defensive Inves- Stock screens with high overall vola- ology. It is easier to stay the course if
tor—Utility Screen first seeks companies tility, as measured by standard deviation, you are investing with a methodology
with total assets greater than or equal to but relatively low downside volatility, that you believe in. Also, be sure to keep
$200 million. The screen then identifies as measured by the Ulcer Index, are in mind that growth portfolios tend to
companies with strong financial condi- especially attractive. These stocks’ price take a larger time commitment to suc-
tion and earnings stability, and those that movements tend to be to the upside in- cessfully administer. If you do not have
pay a dividend, exhibit earnings growth stead of to the downside. The Piotroski the time and energy to closely monitor
and have moderate price-earnings and Screen is a great example, with a risk an investment portfolio, a value strategy
price-to-assets ratios. index over 2.00 and an Ulcer Index of may suit you better.
In contrast, AAII’s MAGNET 14.9%, below the median Ulcer Index Furthermore, a stock screen should
Simple screen has had the highest risk of all the screens (16.6%). only be the first step in the investment
index and standard deviation of returns For a more in-depth description research process. While it is easy to get
since 1998. Accordingly, its annualized of the Ulcer Index, see the Technically enamored with the performance of
return of 17.7% since 1998, which is Speaking column in the Third Quar- various screening methodologies, it is
on the high end of all screens, becomes ter 2013 issue of AAII’s Computerized prudent to perform additional analysis
a much more pedestrian risk-adjusted Investing. on each company that passes a screen
return of 10.2% since 1998. before buying shares. Try to resist the
A MAGNET stock, according Martin Ratio urge to use screens as simply a buy and
to Jordan Kimmel, offers a blend of sell list.
technical and fundamental character- The Martin ratio takes the Ulcer Finally, the nature of how screens
istics. Kimmel believes the MAGNET Index one step further. The ratio is are created leads to certain types of
process “encompasses the best of the calculated by subtracting the risk-free stocks passing certain screens. As you
momentum aspects of the market, while rate from the return and dividing this can see from Table 1, there are numerous
demanding the downside protection of total by the Ulcer Index. The ratio, much categories of screening methodologies.
a value approach and insisting on top- like the Sharpe ratio, measures returns From a diversification standpoint, it
line revenue growth.” The MAGNET above the risk-free rate per unit of risk, is beneficial to follow several screens
acronym stands for the following: with the unit of risk being the Ulcer with differing methodologies. This will
M—Management must be outstand- Index. The main difference from the enable you to diversify your investment
ing; momentum must be improving; Ulcer Index is that the Martin ratio does portfolio across different sectors, styles
A—Acceleration of earnings, rev- not penalize investment methodologies and market capitalizations. 

Joe Lan, CFA, is assistant financial analyst at AAII. Find out more about the author at www.aaii.com/authors/joe-lan.

January 2014 15
 Beginning Investor
A series providing guidance for new investors on how to become successful investors. See AAII.com for the other articles in this series.

Determining How Much to Allocate to Each Investment

The influence any single investment has on your overall Within asset classes, some securities rise, some stay flat and
portfolio’s performance depends significantly on its posi- some fall. Even if all of the individual investments in your
tion size. Position size is the percentage of portfolio dollars portfolio do move in the same direction, the magnitude of
allocated to a specific investment, such as a stock. To use the price changes will differ. This causes the position sizes
a simple example, say an investor has a $100,000 portfolio to be ever-shifting.
invested in 20 stocks. Under an equal-weight scenario, each Small divergences are not significant. If one investment
stock would have a position size of 5% of the overall port- accounts for 6% of the portfolio’s overall value instead of
folio’s value. In other words, $5,000 would be invested in 5%, the proportionately higher risk posed by that one invest-
each of the 20 stocks. ment is not significant. The transaction costs of constantly
bringing the portfolio back to an equal weighting can ne-
gate the benefit of making small changes. This is why even
Focus on Dollars, Not Shares equal-weighted funds tend to limit how often they adjust the
position sizes of each investment.
Notice how the number of shares is not discussed. When Bigger divergences, however, deserve attention. If one
allocating, focus solely on the amount of dollars and not the asset class (e.g., stocks) realizes higher returns than another
number of shares. If you focus on shares, you could end up asset class (e.g., bonds), the risk profile of the portfolio is
buying 100 shares of a stock trading at $20 and 100 shares altered. During a bull market for stocks, the portfolio could
of a stock trading at $50. The dollars at risk are $2,000 and become too tilted toward stocks and incur more price vola-
$5,000, respectively—a big difference. If you allocate $5,000 tility than you are comfortable with. In such situations, it
to each stock rather than being concerned with how many makes sense to rebalance across asset classes, which, in this
shares you are buying, the amount of money at risk is the example, entails shifting dollars out of your stocks and your
same for the two stocks. stock funds and buying bonds and bond funds.
Going back to the original example of a 20-stock port- Within an asset class, if one or two investments perform
folio, if the price of any one of the stocks were to drop to exceptionally well, their position size could become excep-
$0, the maximum downside risk posed to the portfolio by tionally large. This could not only lead to greater investment-
that particular stock would be 5%. Since your dollars are specific risk (the potential damage to your portfolio caused
distributed evenly, each stock’s downside risk is also evenly by a significant drop in one security or fund), but also alter
distributed. your portfolio’s overall allocation. In such scenarios, first
What if you held a smaller number of investments? The check to see if the investment’s valuation is too high. If so,
percentages would change accordingly. In a portfolio equally consider selling it outright. If not, consider reducing the
distributed between five stocks and five funds, each investment position size down closer to the average dollar amount of
would pose a maximum downside risk of 10%. The lower your other holdings to reduce the investment-specific risk.
the number of investments you hold, the larger the risk each
investment poses to your portfolio. Conversely, holding more
securities (stocks, bonds, etc.) and funds decreases the risk Establish Reasonable Bands
each investment poses. This is why diversification depends
in part on holding an adequate number of securities.
of Divergence
The key is to establish bands of divergence wide enough
Periodically Take Action to to let your winning investments run, but not so wide that
position sizes become too large. A useful rule of thumb is
Maintain Balance to adjust your asset class allocations when they move five or
10 percentage points off target. For individual investments,
Equal weighting only lasts temporarily since stocks and consider paring or selling them when their position size grows
bonds, and funds that hold them, do not move in lockstep. beyond 2.5 times the average size of your other investments.
—Charles Rotblut, CFA, Editor, AAII Journal

16 AAII Journal
 Stock Strategies

Exploiting the Relative Outperformance

of Small-Cap Stocks
By John B. Davenport, Ph.D., and M. Fred Meissner

Article Highlights
• Small caps outperformed large caps 51% of the time between 1926 and 2012, but realized a cumulative excess return of 253%.
• There are certain economic conditions that are more favorable for small-cap stocks relative to large-cap stocks.
• Small-cap sectors realize higher returns than large-cap stocks when the large-cap sectors are in favor.

Since Rolf W. Banz first also delivered a cumulative excess return

of 253% relative to large-company stocks.
posited the size effect of equity
Given the variability of relative returns
returns in a 1981 study published in
of small-cap equities versus large-cap equi-
the Journal of Financial Economics, ties, the question for investors is which environments
the relative outperformance of small-capital- or economic conditions are most conducive to small-cap
ization (small-cap) stocks compared to large- stocks outperforming large-cap stocks. This article explores
this very question. We explore several hypothesized scenarios
capitalization (large-cap) stocks has remained
that conceptually make sense as to producing favorable en-
a steady point of debate within the investment vironments for small-cap stocks.
management literature.
Even a cursory review of the annualized returns since Theoretical Foundations
the inception of the S&P SmallCap 600 index shows that
the small-cap index has produced a higher cumulative return Modern portfolio theory as espoused by Harry Markowitz
than the large-cap S&P 500 index (209.02% versus 188.13%). suggests that assets that demonstrate higher levels of risk,
The nature of this outperformance has been one of the as defined by standard deviation (“volatility”), would require
central points of discussion within the literature. Of primary higher levels of returns to investors for assuming the additional
concern is the variability over time of this outperformance, relative risks versus other assets. Therefore, for investors who
as discussed in a 1983 Journal of Financial Economics study have higher tolerances for risk, higher standard deviation
by Philip Brown, Allan W. Kleidon, and Terry A. Marsh. assets, over time, should produce higher returns. Investors
Sherman Hanna and Peng Chen found that small-cap equities often assess the value of underlying organizations via some
were riskier equity investments relative to large-cap equities form of discounted cash flow. Equity prices then reflect the
for holding periods of less than 15 years, while they were perceived value of these discounted cash flows, as suggested
less risky for holding periods of longer than 15 years in their by Jonathan Berk in a 1997 Financial Analysts Journal study.
July 1999 AAII Journal article, “Small Stocks vs. Large: It’s More precisely, equity prices, more often than not, at-
How Long You Hold That Counts.” tempt to reflect the visibility of these discounted cash flows.
A review of Eugene Fama’s and Kenneth French’s small- Small-cap stocks tend to have three primary characteristics
versus-big index series shows that in monthly returns between that diminish the visibility of future cash flows. First, small-
July 1926 and February 2012, small-cap stocks outperformed cap stocks will often have shorter track records upon which
roughly 51% of the time. During that time, small-cap stocks to build cash flow assumptions. Second, small-capitalization

January 2014 17
Table 1. Small-Cap Excess Returns measured by falling unemployment. as provided by the U.S. Bureau of Labor
Following U.S. Recessions Our third hypothesis is born out of Statistics. We have also gathered small-
observations by LeRoy Brooks and Gary cap equity returns relative to large-cap
Post 12 Mo.
Porter, in their 2012 Financial Services equity returns. For this, we have used
Recession Excess Return
(Ending Year) (%) Review study. They found that there is a the Fama and French small-versus-big
growing body of literature that suggests index returns. This data series extracts
1948 2.18
investors can extract portions of stock the excess returns of small U.S. equi-
1953 (1.32)
market returns by exploiting various ties versus large U.S. equities as defined
1957 10.48
information signals related to size, style by market capitalization. The intent is
1960 1.60
and other subsets of the broad market. to determine whether these points of
1970 7.25
Sector rotation strategies have long been economic data can be used as predictive
1973 9.79
a method for investors to attempt to measures of when to favor large-cap
1980 17.45
extract such portions of equity returns. equities versus small-cap equities in
1990 8.73
However, the literature has not given investment portfolios.
2000 24.84
ample attention to examining the size With these data sets we then
2008 8.50
effect of sector rotation. Within sector cross-referenced the excess returns of
rotation strategies, investors posit that by small-cap equities against various time
making the appropriate sector allocation periods within the GDP and unemploy-
companies may be less widely followed at the various points in the economic ment series.
by Wall Street analysts. Lastly, investors cycle, they can add excess returns to the
may perceive small-capitalization stocks broad market. If we extend this argu- Small-Cap Sector Rotation
as more economically sensitive assets. ment beyond just the sector allocation To examine the concept of a size
All of the above factors may have im- to include a size allocation as well, the effect on equity sector rotation strategies,
plications as to when small-cap stocks question arises as to whether the presum- we gathered monthly investment index
should theoretically outperform less ably higher-risk and thus higher-reward returns of the large-cap S&P 500 index,
risky equity assets. small-cap equities within those specific the S&P SmallCap 600 index and each
As Zaugang Liu and Jia Wang sectors will perform better. Therefore, of their respective sector indexes. We
surmised in a 2010 Financial Services our third hypothesis is presented: then calculated periods of positive equity
Review article, large-cap growth stocks • H3: When specific equity sectors of returns as found within the broad market
appear to be the safest equity investment the broad market are in favor, small- index (S&P 500). We then calculated
for investors with short time horizons, cap constituents of the respective excess returns of each sector of the
while small-cap equities are the most sector should perform better than S&P 500 relative to the S&P 500 itself,
profitable for long-term investment ho- their large-cap counterparts. which would then indicate favorable
rizons. However, these findings consider conditions to allocate additional assets
only time horizon and do not sufficiently Methodology to that sector. Lastly, we calculated the
explore the variability of returns across excess returns of the small-cap sector
changing macroeconomic conditions. Our two hypotheses attempt to to the broad market.
With respect to the economic sensitiv- address small-cap equity performance
ity and visibility of future cash flows, relative to that of their large-cap coun- Findings
it would intuitively follow that higher terparts. In this study, we are attempt-
risk assets that are more economically ing to address how small-cap equities Hypothesis 1: Small-Cap Excess
sensitive may outperform in time of perform under various conditions: Returns Relative to GDP
improving macroeconomic conditions • Are there economic conditions that The findings suggest that there are
and conversely underperform in times are more conducive to small-cap certain economic conditions that are
of deteriorating economic conditions. equities performing better than more favorable for small-cap excess
This leads us to hypothesis #1 and large-cap equities? returns relative to large-cap equities.
hypothesis #2: • In a sector rotation strategy, can An examination of the GDP data
• H1: Small-capitalization stocks will small-cap equities deliver excess series suggests that in a period of ex-
outperform when macroeconomic returns? panding economic activity—i.e., when
conditions as measured by gross GDP is increasing—small-cap stocks
domestic product (GDP) are im- Small Cap Versus Large Cap and tend to outperform large-cap equities.
proving. Economic Indicators Further, the data suggests that for the
• H2: Small-capitalization stocks To explore our first premise, we have four quarters following the official end
will outperform when improving gathered quarterly U.S. economic data of a period of contracting economic
macroeconomic conditions are via GDP and U.S. unemployment rates activity, small-cap equities outperform

18 AAII Journal
 Stock Strategies

large-cap equities. In our data series Hypothesis 3: Small-Cap Sector Table 2. Small-Cap Excess Returns
going back to 1948, we identified 10 Excess Returns Following Recessions With Falling
periods of prolonged contracting eco- This analysis was performed under Unemployment
nomic activity sufficient enough to be specific assumptions. First, we deter- Recession/Falling Post 12 Mos.
labeled a recession. Following the end mined periods of favorable equity re- Unemployment Excess Return
of those recessionary periods, small- turns as measured by positive monthly (Ending Year) (%)
cap equities outperformed in nine of returns of the S&P 500 index, also 1948 2.18
the 10 recessions in the ensuing four referred to as the broad market. We also 1952 (1.32)
quarters. These recessions are listed in then identified periods in which each 1957 10.48
Table 1 along with the cumulative excess of the 10 respective S&P 500 sectors 1960 1.60
return of small caps in the following outperformed the broad market. Op- 1970 7.25
four quarters. erating from the premise that higher- 1974 9.79
These periods of excess returns risk assets in times of favorable equity 2008 8.50
were analyzed and found to be statisti- environments should produce higher
cally significant. Further, small-cap equi- returns, we then calculated whether
ties produced cumulative excess returns the small-cap sector counterpart (S&P added excess returns more than 50%
of 89.5% for all these periods, inclusive SmallCap 600) outperformed their large- of the time. Utilities, materials, informa-
of the 1953 recession when small-cap cap counterpart. tion technology, healthcare, energy and
stocks delivered negative excess returns. The results demonstrated high consumer staples all outperformed 70%
We also ran correlations of the percentages of outperformance for or more of the time. The excess returns
small-cap excess returns to periods of each of the respective small-cap sector of each small-cap sector, with the excep-
rising and falling GDP and found that indexes. There were 220 monthly periods tion of the utilities sector, were statisti-
small-cap excess returns were negatively observed in our data set. Table 3 demon- cally significant, providing a relatively
correlated to falling GDP and the results strates how often each of the respective high level of confidence in providing
were statistically significant. Small-cap large-cap sectors outperformed within excess returns via a small-cap sector
excess returns were only slightly posi- the 220 monthly periods. Further, the usage in a sector rotation strategy. The
tively correlated to the entire data series. table demonstrates how often the small- least-consistent small-cap sectors were
Therefore, Hypothesis 1 is accepted. cap sectors outperformed when the consumer discretionary and financials,
large-cap sector was in favor. Addition- only outperforming 57% and 61% of the
Hypothesis 2: Small-Cap Excess ally, the table illustrates the cumulative time, respectively. However, the excess
Returns Relative to Unemployment excess returns of the small-cap sectors returns of the consumer discretionary
We conducted a similar analysis of versus the S&P 500 during the periods sector were statistically significant.
small-cap excess returns against U.S. un- of outperformance of the large-cap
employment rates, again using quarterly sectors relative to the broad market. Limitations of the Study and
data going back to the first quarter of The results show that all small-cap Future Research
1948 through the fourth quarter of 2012. sectors added excess return when the
Small-cap excess returns were found large-cap sectors were in favor. Ad- Index Construction
to be only slightly negatively correlated ditionally, all of the small-cap sectors Excess returns of small-cap equities
(–0.14) to unemployment rates and the
results were not statistically significant.
Therefore hypothesis #2 is not accepted. Table 3. Small-Cap Sector Excess Returns
However, we did cross-reference
periods of expanding GDP following a # Times # Times Outper- Small-Cap Sector
Large-Cap Sector Small-Cap Sector formance Excess Returns
recession, which also corresponded to a Sector Outperformed Outperformed (%) (%)
cumulative drop in unemployment rates
during the same four-quarter period. Utilities 104 78 75.00 1.69
Examining the four quarters following Telecommunications 107 73 68.22 5.16
a recession where unemployment rates Materials 103 80 77.67 2.62
were also falling, we identified seven time Infomation Technology 110 77 70.00 2.21
periods. As shown in Table 2, small-cap Industrials 112 77 68.75 2.11
equities delivered excess returns in six Healthcare 111 85 76.58 3.39
of those seven periods, a success ratio Financials 110 67 60.91 1.66
of 86%. During these seven periods, Energy 112 82 73.21 4.27
small caps delivered excess returns of Consumer Staples 109 82 75.23 2.83
38.48% relative to large caps. Consumer Discretionary 123 70 56.91 2.68

January 2014 19
versus large-cap equities within the ex- research may look to aggregate excess re- with their higher standard deviation
amination of post-recessionary periods turns from various index methodologies. would need to deliver excess returns to
and periods of falling unemployment investors for that additional risk. The
were conducted relying on underlying Timing of Sector Rotation variability of these excess small-cap
index methodology as presented by Implementation returns is a problem that has been noted
Fama and French’s definitions of small Our analysis of excess sector returns throughout the investment management
stocks versus large stocks. assumes that an investor demonstrates a literature.
Excess returns at the sector level high level of proficiency at making the This study sought to examine spe-
were conducted with the index con- appropriate sector ‘bet’ at the appropri- cific assumptions as to whether there
struction methodology of Standard & ate time. The value of these findings may are identifiable economic periods where
Poor’s, using the S&P SmallCap 600 be limited by investor proficiency. The these excess returns are more likely to
as the definition of small-cap equities discussion as to whether investors can, occur. Our findings suggest that inves-
and the S&P 500 as the definition of with any proficiency, correctly identify tors have higher probabilities of captur-
large-cap equities. This was done given and allocate assets to the appropriate ing small-cap excess returns in times
the prevailing popular acceptance of sectors relative to the broad market is a of economic expansion immediately
the S&P sector definitions within the separate discussion for another research following recessionary periods. Further,
practicing investment profession. effort. we found that investors can also capture
Results of this study may be influ- relative excess returns at the sector level
enced by the reliance on these distinct Conclusion by investing in the small-cap sector
methods of index construction. There when the accompanying large-cap sec-
are numerous readily accepted means This study attempted to examine tor is outperforming the broad market.
of index construction (index providers, the nature of the variability of excess While the findings are not meant to be
market-cap weighted, fundamentally returns of small-cap equities relative to a definitive approach to any specific
weighted, etc.) that may vary the mean- large-cap equities. Given Markowitz’s investment process, it does help provide
ingful contribution of excess returns of assertion that higher-risk stocks should some direction in the further exploration
small caps versus large caps as defined deliver higher returns to investors, of the variability of small-cap excess
by those varying methodologies. Future it is presumed that small-cap stocks returns over time. 

John Davenport, Ph.D., is a regional portfolio consultant for Invesco PowerShares Capital Management LLC. M. Fred Meissner,
CMT, is president of the Fred Report, which provides financial market research based on technical analysis. Find out more about
the authors at www.aaii.com/authors/john-davenport and www.aaii.com/authors/fred-meissner.

20 AAII Journal
 Trading Strategies

To Trend or Not to Trend

By Ray Rondeau

Article Highlights
• Combining technical, fundamental and implied volatility indicators can give valuable insight into trend analysis.
• Price action is related to and influenced by the technical landscape of the charts.
• Technical analysis does not necessarily predict price action, but indicates where and when a trend is likely to resume its path.

It is obvious that mar- future price action. Specifically, I

kets change and markets discuss three primary areas to help
evolve. Investors who accept you differentiate between a normal
this as reality and adjust retracement of a strong continuing
their approaches accord- trend and the early warning signs
of a major trend reversal. In other
ingly put themselves in a words, the primary question is “to
better position to succeed. trend (continue) or not to trend
Like seemingly everything (reverse)”?
today, markets and their characteristics are changing at an
ever-increasing pace. One of the more apparent changes is Price Action and Trend Changes
that we seem to be in an endless series of boom/bust cycles.
These “bubbles” are being formed by a continuous revolving For the purposes of this article, I define a trend simply
series of overextended price trends. as the general direction of a market or the price of an asset.
An investor may attribute these changes to multiple With today’s extensive financial news coverage, investors are
factors, including globalization, technological advances, the often well aware of the overall direction and trends of the
Internet, constant media coverage, increases in automated major indexes and their respective components. Unfortunately,
high frequency trading or the growing amount of hedge fund simply knowing the direction of the trend isn’t enough for
assets. New investment vehicles designed to allow individual evaluating potential directional changes. For this, an inves-
investors to short and/or leverage (while staying long) is also tor needs to get some deeper insight into the characteristics
a likely contributor. Add in ultra-low commissions and the of the established trend, such as the longevity, intensity and
fact that an investor can change his entire portfolio with a developing changes in momentum. This leads us to an obvi-
few clicks of a button, and it is easy to see why markets seem ous starting point, charting and technical analysis, where a
to be trending longer and wider than at any point in history. picture is truly worth a thousand words.
Regardless of the reasons why, the fact is that our markets To illustrate, I have chosen the popular investment/trading
are trending. Popular or not, an elementary understanding vehicle gold. From the beginning of 2000, gold had been on
of trend analysis theory in today’s market environment is no a decade-plus upward climb from a price of $280 per ounce
longer a complementary addition, but rather a necessity to in January 2000 to over $1,950 per ounce in September 2011.
maximize the chances of success. This rise of nearly 600% certainly qualifies as an established
This is the focus of this article as I explore where an long-term uptrend. Figure 1 shows that, using only basic
investor should turn to in evaluating trends and probable support and resistance levels, the charts did an excellent job

January 2014 21
Figure 1. Technical Analysis of Gold intermediate-term price direction for
gold going forward from that point.
After a two-month battle, the bulls
abandoned the $1,546 level and prices
collapsed $200 (12.7%) in two days.
Here, both experienced bullish and
bearish technical traders would have
transacted correctly once the market
had finally showed its hand. The bulls
would have been stopped out below
the $1,546 level and retreated to fight
another day, and the bears would have
profited by establishing or adding to their
short positions. The huge volume spike
at point K is noteworthy and was further
evidence of the importance associated
with this technical event.
This example highlights three key
Source: Chart was created using TradeStation. ©TradeStation Technologies, Inc. 2001-
points. First, popular or not, price ac-
2013. All rights reserved. No investment or trading advice, recommendation or opinions tion is related to and influenced by the
are being given or intended. technical landscape of the charts, and
technicals can be used to assist one in the
timing of executions. Second, the failure
of not only forecasting future price prophecy of price movement. of the price to hold support at point J
movements for shorter trading profits, At point H on Figure 1, there was reaffirms that technical analysis doesn’t
but also identifying the overall end to the third touch of the now-confirmed tell us necessarily if a price trend is going
the primary upward trend, which is our short-term downward sloping trend to continue, but only indicates where
primary goal. line, extending from point G. This was and when the trend is likely to resume
If an investor was bullish on gold an excellent short opportunity, forcing its path. Third, price action at these key
and looking to establish a long position, the price into another price void, and inflection points has significant value in
point C on Figure 1 would have been a it would not have taken much technical determining the probable continuation
fairly obvious first choice. Here, there expertise to deduce that the next logical or change in an established trend—our
is a level of support, extended from battle area would have been back at the main goal. In this example, once the
points A and B, where buyers showed $1,546 price level. This, of course, was price of gold breached the $1,546 level
a previous interest in accumulating not only self-fulfilling, but also logical at point J, the charts signaled that the
shares around the price of $1,546. At and where active traders make their intermediate and possibly the long-term
point D, there was more evidence sup- money. At this point, future bullish uptrend was over.
porting the bullish position, with the investors would have been hesitant to
breach of the intermediate downward purchase shares at higher price levels Combing Technical and
sloping trendline (green block arrow). when they felt that they may have been Fundamental Indicators
With gold having moved into a huge able to get a better price at $1,546, so
“price void,” the next logical stop would they waited. Bearish investors were not Rightfully so, longer-term-oriented
have been at the next area of resistance going to close their short positions at a investors love to look at fundamentals
around the $1,810 level. This was an area higher price, and hence they were prone for making their investment selections.
of clear resistance, where sellers had to also wait for prices to fall back to the Thus, incorporating these valuations
shown a previous desire to distribute $1,546 level. Both parties were reluctant into analysis for probable continuation
shares. (Points E and F on Figure 1 to transact, in hopes that they could get or reversal for long-term trends is not
established this resistance.) At point better prices. The hesitation by the bulls only reasonable, but also effective.
G, bullish investors would have looked and the bears completed the technical One measure of fundamental valu-
to take profits, while bearish investors formation and led to the major key price ation that can be useful to consider is
might have looked to establish new short area on Figure 1: point J. the relative price-earnings (P/E) ratio.
positions. Both of these actions created Point J was an obvious and key The relative price-earnings ratio is a
downward pricing pressure, simply be- inflection point for the long-term trend comparison of stock’s current price-
cause of the technical landscape of the and the world was watching. What earnings ratio to that of its history. For
charts, essentially causing a self-fulfilling happened there likely determined the the purposes of this article, I include

22 AAII Journal
 Trading Strategies

a graphed example of relative price- Figure 2. Technical and Fundamental Analysis of Lockheed Martin
earnings ratios in conjunction with
support and resistance.
Figure 2 shows the price action
of Lockheed Martin Corp. (LMT)
coupled with its price-earnings ratio
(lower pane). The interpretation here is
that a low numerical reading would be
viewed as a potentially bullish reading,
indicating a “relative” historical-based
low and perceived attractive valuation.
In Figure 2, we can see that whenever
the price-earnings ratio approached a
level of 9.0—the lower band of fun-
damental support—buyers stepped
in. At the opposite side, when Lock-
heed’s price-earnings ratio approached
11.0—the upper band of fundamental
resistance—the price seemed to roll over Source: Chart was created using TradeStation. ©TradeStation Technologies, Inc. 2001-
as the sellers seemed to take control. 2013. All rights reserved. No investment or trading advice, recommendation or opinions
Coupling these fundamental sup- are being given or intended.
port and resistance areas with the price
action (points A, B and C on Figure 2) is
where we get our insight into the likeli- mental studies for trend analysis are regression price channel (lower green
hood of the technical trend continuing obviously and widely used, but for line) as support for the established trend.
or breaking, again our primary purpose. additional insights we will now look To get a benchmark, I first do some
If the price has been ranging and is cur- at one example in our third area of quick calculations starting at point A.
rently at the lower edge of price support, study—derivatives. Point A marks a 4.9% price pullback
we would want to see a fundamental within the channel and a VIX peak
indication that the stock is undervalued. What Investors Might of 23.23. Point B marks a 5.3% price
A low relative price-earnings ratio would Be Thinking pullback within the channel and a cor-
be bullish and would confirm the likeli- responding VIX peak of 21.3. Using
hood of the trend continuing. By looking at the implied volatility these as the reference levels, look at point
Conversely, if the stock approached (IV) of optionable issues, the investor C to observe a similar size pullback of
support (lower prices) and was still trad- has the ability to gain some additional 4.7% to support, but with a subsequent
ing with a high relative price-earnings insights (that are not only shown in rise in the VIX to only 17.8. An inter-
ratio, then this could be a interpreted price) into what market participants pretation here could be that there was
bearishly with an increase in the prob- might be thinking. This measurement less demand for protection in relation
ability of a breach of the existing trend. has potential forecasting value when to other recent pullbacks and that the
Often this can lead to a scenario where issues approach extreme relative his- overall market had less concern with this
fundamental-oriented investors begin to torical implied volatility levels or when retracement and a major trend change.
liquidate their positions. This liquidation it creates divergences with price that In hindsight, we can see that this is what
then causes a drop in price that prints a cannot be directly associated with other happened, as support did hold and the
bearish technical pattern on the charts known factors. price continued to reach a higher high.
(a breach of major support), which fur- To illustrate, Figure 3 shows the Moving forward at point D, a similar
ther exacerbates the selling, now by the S&P 500 index and the widely used “fear “high” VIX reading of 20.34 can be
technical traders. The additional pricing index,” the Chicago Board Options Ex- seen. This new “high” reading, though,
pressure begins to trigger protective change (CBOE) Volatility Index (VIX). occurred in the toxic environment of a
stops on established long positions. The classic interpretation in action at partial government shutdown, with the
Automated trading programs designed points A, B and C of “when high, it’s threat of a possible U.S. government
to recognize such activity then jump in, time to buy, and when it’s low, look out debt default. Considering the amount of
adding to the building of momentum below” appear on this chart. How high uncertainty, when an investor compared
and the subsequent forming of a new is high and how low is low? For this this reading to the average VIX reading
trend in the opposite direction. example, I will use the VIX levels as of 20.32 (from January 2004), he could
The use of technicals and funda- the reference and the bottom of a linear theorize that the big money and those

January 2014 23
Figure 3. Analyzing Implied Volatility (VIX) sustainable uptrend that has just broken
out of a major continuation pattern,
off of multiple key converging moving
averages on high volume with a gap into
a huge price void. The stock could also
be showing continued but sustainable
relative strength and leadership to the
market and its industry. It could have
true insider (non-stock option related)
buying, positive price movements to
seemingly negative news and be enter-
ing a favorable seasonable cycle for its
industry, all while being at the very top
of your favorite stock adviser’s lists and
newsletters. Yet, we still would not know
what the stock price is going to do.
In this one-sided scenario, it would
be natural for one to assume that with all
Source: Chart was created using TradeStation. ©TradeStation Technologies, Inc. 2001-
the overlapping and reinforcing positive
2013. All rights reserved. No investment or trading advice, recommendation or opinions signs that we would know what the stock
are being given or intended. price is going to do, right? No, no one
really knows (barring inside information
or manipulation). Even if everything that
who were “in the know” did not seem who question a lot and seem sure of you know is complete (impossible) and
overly concerned. In other words, based little. As Oscar Wilde once stated, “the totally true (unlikely), it is important to
on this one indicator, an investor could pure and simple truth is rarely pure and remind ourselves of the famous quote
have surmised that the market had a never simple.” In the investment world, attributed to John Maynard Keynes,
relatively bullish stance and that there the truth is, despite what someone may “The market can stay irrational longer
would be a satisfactory resolution and try to “tell you or sell you,” the markets than you can stay solvent.” Unfortu-
future upward price activity. Again in are not stupid. Attaining a true edge on nately, price and trend analysis is about
hindsight, we now know that this was longer-term-oriented positions takes probabilities and never guarantees. This
indeed the case, even though only a good resources, hard work and research. is the reason that experienced investors
short-term solution to the concerns Our markets are more sophisticated look to protect assets with diversification
was reached. than ever. Simple get-quick-rich schemes and hedging strategies.
Conversely, let’s say the VIX instead don’t work here. All of this leads us to Now the unpopular truth: If some-
jumped to a hypothetical level of 45 at a few final thoughts in regard to trend thing on initial analysis looks too good
point C. In this scenario, one interpre- analysis and price forecasting. to be true, it probably is. So look further
tation might have been that there was First, the good news. After research- and then, if necessary, even further.
a high degree of fear with this similar ing, when these observations are com- There are no free rides on Wall Street.
measured price pullback and that the bined they can give an investor valuable Yes, an argument can be made for the
current trend and support was less likely insights into the health of a current “analysis paralysis” side of the debate.
to hold. Here, an investor could have trend. In addition, it is important to note But scanning the entire field for hid-
theorized that the market’s larger play- that these measurements are more effec- den sinkholes before sprinting to pick
ers were more pessimistic or concerned tive when used together, as they work up your pot of gold at the end of that
about the eventual outcome. synergistically. Single observations or rainbow (that you assume no one else
the use of a single indicator is generally sees) just makes more sense.
A Synergistic Viewpoint less effective. A professional investor One could argue that the markets
will consider researching many factors, may not be totally efficient, but market
After decades of working with and not just those that are quantitative, participants are not totally incompetent
individual and groups of traders and before making an informed “decision.” either. As anything changes—either real
investors, I have often noticed that George Bernard Shaw once stated or perceived—the markets and prices
novice or unsuccessful investors are the that “the [only] golden rule is that there adjust immediately to reflect that new
ones who seem to question little and are no golden rules” and this the bad information. Put another way, everything
seem sure of a lot, while the proficient news investors must face. You can have that has happened, is expected to hap-
and successful investors are the ones a stock that technically has been in a (continued on page 36)

24 AAII Journal
 Insurance Products and Annuities

Long-Term Care of Your

Personal Finances
By Christine Fahlund, Ph.D., CFP

Article Highlights
• Covering the costs of long-term care should be part of your financial planning. Insurance is one way to provide for those expenses.
• Long-term care insurance can help you maintain a larger allocation to stocks, which provide better longevity and inflation protection.
• Triggering conditions and their elimination (waiting) period determine when benefits will be paid.

Your odds of needing long- is to stay in your own home as long as

term care—care to help you with
possible and to maintain control over
the activities of daily living—are your care for as long as possible, consider
seven out of 10. purchasing some form of long-term
According to the 2011 handbook care insurance. The more coverage you
of the American Association for Long- pay for, the more choices you will have.
Term Care Insurance, 70% people over The costs of providing long-term
the age of 65 will require long-term care, either at home or care are significant. According to the government-run website
in a facility. And with medical advances keeping people alive LongTermCare.gov, average costs for long-term care in the
but not necessarily healthier longer, the odds may change— United States (in 2010) were:
and not in your favor. • $205 per day, or $6,235 per month, for a semi-private
Don’t be lulled into a false sense of security because room in a nursing home;
you have good health insurance or by thinking you can rely • $229 per day, or $6,965 per month, for a private room
on Medicare. Long-term care isn’t the same as care during in a nursing home;
an illness or for an emergency medical condition, so it isn’t • $3,293 per month for care in an assisted-living facility
covered by health insurance or Medicare. Long-term care (for a one-bedroom unit);
is defined as assistance with the activities of “daily living”: • $21 per hour for a home-health aide;
bathing, continence, dressing, eating, toileting and transfer- • $19 per hour for homemaker services; and
ring. Most policies today also cover cognitive impairment • $67 per day for services in an adult day health care center.
(such as Alzheimer’s disease). The older you are when you purchase coverage, the
Long-term care can occur either in your own home or higher the annual premiums. On the other hand, the younger
in a facility, such as a nursing home or an assisted-living you are, the more years you will be paying premiums. (For
situation. Be sure to read the fine print with respect to care information about long-term-insurance care costs, visit the
in your own home, as policy coverages may differ. (See the American Association for Long Term Care Insurance’s website
sidebar titled “Read the Fine Print.”) at www.aaltci.org.)
There are three ways to pay for long-term care: By self- If you don’t factor the possible need to pay for long-term
insuring (i.e., having no insurance, and paying all of your care, either through insurance or out of pocket, into your
costs out of pocket); by having some sort of long-term care financial plans, it could play havoc with your financial stability
insurance coverage; and by relying on Medicaid, which requires down the road, and your ability to leave anything behind for
that you exhaust almost all of your financial resources in your heirs. And how you choose to cover those expenses could
order for the government to pay for your care. If your goal have an impact on how you invest your money in retirement.

January 2014 25
 Read the Fine Print
There are almost limitless numbers of variations with Benefit Duration and Amounts
regard to long-term care coverage. Two policies of the • How much will the policy pay per day for care in
same type from different companies could have different a nursing home, assisted living facility, or at home?
levels of coverage, and prices vary as well. • Do the benefits increase with inflation?
While it’s important to understand any kind of insur- • What are the limits, if any, for the number of days
ance policy—or any document you sign, for that matter— or visits per year for which benefits will be given?
it’s especially important with long-term-care insurance • What are the dollar limits on the amount the policy
because it is very difficult, not to mention expensive, to will pay during your lifetime? Are there limits for
change your coverage once you start receiving benefits. each different kind of care or facility?
You may want to consider consulting with a lawyer who
specializes in elder care when evaluating policies. Eligibility and Triggers
Below is a list of some of the areas and issues you • What is the waiting period (aka elimination period)
may want to go over in greater detail. It is by no means for when benefits begin? Does the waiting period
exhaustive, but is meant to serve as a starting point: differ depending on what kind of care you are get-
ting or where it is administered? Are waiting periods
Levels of Care cumulative or consecutive?
• Will you be covered for skilled nursing care? For • Which trigger(s) will start your benefits? How many
personal/custodial care? activities of daily living do you need help with for
benefits to trigger?
Where You Can Receive Care
• Will your care be covered in any licensed facility—nurs- Miscellaneous
ing home, assisted living, adult day care, other facilities? • Are your premiums deductible as a medical expense?
If there are exclusions, what are they? Will your benefits be taxable or income tax-free?
• If you are receiving care at home, will you be covered • What happens to your policy if you can no longer
for benefits provided by skilled nurses, home health afford the premiums?
aides, homemaker services, family members, or other • If your policy is later acquired by another insurance
providers? company, can the terms of the policy be changed?

Should You Buy? of long-term care can certainly fall into ered via insurance is that you will have
that category. the freedom to keep a larger percentage
Long-term care insurance is de- in stocks in your portfolio, which will
signed to allow you to have more con- Investment Alternatives provide needed growth potential (i.e.,
trol over your destiny if your health longevity and inflation protection) over
deteriorates. (One way of thinking How you choose to provide for the long term.
about it is as “stay in your own home” the possibility of long-term care will The time to buy long-term care
insurance). It can also be just as im- likely affect how you invest, not only insurance is well before you need it.
portant for couples as it is for single for your retirement but also during your Generally, the younger and healthier
people or those without children or retirement. If you’re self-insured, you you are, the less expensive the premiums
family nearby, since it can free up loved need to have ready access to some of will be. Also, you are more likely to be
ones—a spouse, children, grandchildren, your assets, which you set aside in cash insurable. The emergence of a condi-
siblings—from having to provide care and short-term investments to cover tion such as diabetes or high cholesterol
for you. Relatives may not be up to the long-term care needs, without having could be seen as a red flag that you are
challenge of providing long-term care to worry about liquidating assets during at a higher chance of needing long-term
because of their own career and family unfavorable market conditions. On the care down the road. Your insurability
obligations or geographic location, and other hand, this allocation to short-term could be affected, or your coverage
there is no guarantee that your spouse investments will limit your flexibility could exclude pre-existing conditions.
will be physically up to the job. to invest a significant portion of your And unlike other forms of insurance,
If you’re by nature a more cautious portfolio in equities. such as fire or theft, which you can
person, you will likely want to be insured An advantage of having these po- buy after an incident (albeit with higher
for catastrophic expenses. And the costs tential long-term care costs largely cov- premiums), this would not be the case

26 AAII Journal
 Insurance Products and Annuities

How & Where to Buy Long-Term Care Insurance

So let’s say you decided you want to buy some form fewer employers provide it as part of their benefit pack-
of long-term care insurance. How do you do it? age. However, some offer it as an add-on that you pay
You may wish to purchase your own insurance policy, for. The advantage to buying it through your employer
or you may prefer to purchase coverage offered through is that it is an easy, available solution. It also will have an
your employer. open enrollment period at the time you join the company
when you will be eligible to purchase coverage without
On Your Own any type of a questionnaire or medical exam.
Begin by contacting your state insurance department If you would otherwise be uninsurable, or have a
to find out if they have any informational materials for pre-existing condition excluded from coverage, this may
residents wishing to purchase long-term care insurance. be your best option. However, you can’t assume that the
Also ask about whether they provide an insurance coun- rates are lower than you could get elsewhere, or that
seling program and how you can benefit from its services the policy is as comprehensive as what you want/need.
before making your purchase.
Then check with several companies and agents and Through Your State
compare the features and benefits (and costs) of their Today, many states offer long-term care partner-
products. Also compare the financial stability of each ship programs. By purchasing an insurance policy that
company you are considering. A variety of rating agen- qualifies as a “partnership policy” (check with your state
cies have websites where you can learn about the financial insurance department), you will receive insurance benefits
strength of each company (e.g., www.ambest.com, www. until your policy is exhausted, at which time the state
moodys.com and www.WeissRatings.com). will enable you to qualify for Medicaid without having
Once you have made your purchase, be sure you look to spend down the amount of money you paid over the
at your policy during the free-look period. In most states, years on long-term care insurance premiums.
if you change your mind, you have 30 days to cancel and This is a potential win-win arrangement for you and
get your money back. the state. In other words, the state delays or avoids paying
you Medicaid benefits and in exchange you are potentially
Through Your Employer allowed to retain more assets to leave to your heirs.
With the escalating costs of long-term care insurance,

with long-term care insurance. Single-Life Long-Term members of a couple. If the policy maxi-
When it comes to choosing a policy, Care Insurance mum is $200,000 and your spouse uses
you will have to decide what kind of As the name suggests, a single-life up $150,000, you are left with $50,000
insurance you want—strictly a long- long-term policy covers just one person. of coverage for yourself.
term care policy (either joint or single), It’s the obvious choice for a single per- While a joint policy is almost guaran-
or as a part of a life insurance policy son who wishes to have and can afford teed to be less expensive than two single
or annuity—as well as the amount of coverage, but some couples choose to policies, you run the risk of one person
coverage. Regardless of how you choose buy two single policies rather than a maxing out the coverage, effectively
to be covered, there are myriad varia- joint one to maximize their coverage. leaving the other person with nothing.
tions (see the sidebar titled “Read the Conversely, some couples only buy
Fine Print”). insurance for one of them. How do you Fixed Annuity With Long-Term
For example, a joint long-term care know which one to buy for, or that you Care Benefits
policy from two different companies both won’t need it? Bet on the wrong A fixed annuity with long-term care
could vary in terms of exclusions, trig- person, and you’re not only out the benefits is usually a single-premium
gers and benefit periods, depending on cost of the premiums, but the costs of product that will provide money to be
what kind of coverage you choose. This care for the uninsured party who ends used for long-term care if needed. Any
is why it’s so critical that you do your up needing it. money that is dispersed for long-term
homework. And as you would expect, care will affect the amount of the an-
premiums vary widely as well. Joint-Life Long-Term nuity at maturation.
Below is a brief summary of the Care Insurance This type of policy is generally less
various kinds of policies, and the pros A joint policy provides a maximum expensive than a traditional long-term
and cons of each. dollar amount of coverage for both care policy, and if you don’t need long-

January 2014 27
term care, you will receive the annuity. need assistance performing at least tion with long-term care insurance the
However, today’s low interest-rate envi- two of the six defined activities of same way.)
ronment currently makes fixed annuities daily living. (The number of activi- Sometimes premiums can be raised
less attractive overall. ties you need help with to trigger significantly for an entire class of poli-
benefits could be another variable.) cyholders. This could happen, as it did
Life Insurance With Coverage for • Cognitive Impairment: You require recently, after bond interest rates fell
Long-Term Care Expenses supervision, direction, and assis- and remained low for an unexpectedly
You can also get long-term care tance with activities of daily living long time, while the insurance companies
benefits by putting your money in a because of cognitive impairment, were depending on bond interest to pay
cash-value insurance vehicle—whole, such as Alzheimer’s disease. for current and future claims. It could
universal, or variable universal life—and You also need to look at the elimi- also happen as the result of revised as-
then electing to purchase “an acceler- nation period—the amount of time sumptions and calculations on the part
ated death benefit” or “life/long-term the triggering conditions must be pres- of actuaries employed by the insurance
care” policy. After you’ve “triggered” ent—before insurance will start paying companies.
the long-term care coverage, any such for your benefits. You will be paying At some point you may find you
benefits that are paid out by the company out of pocket for your care during the cannot afford the premiums anymore.
are subtracted from the policy’s death elimination period. Think of it as the Several options may exist for you, but it
benefit. (Usually the insurance com- equivalent of a deductible in other types is important to consult with the insur-
pany has limits on the daily or monthly of insurance policies. A long elimination ance company at the time you initially
benefits paid, depending on the policy’s period will likely mean lower premiums, purchase the long-term care policy to
death benefit.) Your beneficiaries will but it could also mean significant out- determine which options, if any, will be
ultimately inherit any benefits remaining. of-pocket costs for you. available. Some companies will negoti-
If you want more long-term care A final consideration is the sound- ate with you, for example, to provide
benefits than the life insurance policy ness and stability of the insurance reduced coverage in the future for a
will permit, you can also purchase more company you choose. The recent less- lower annual premium.
long-term care coverage in the form than-favorable economics of meeting Others will offer you a non-forfei-
of a rider. the demands of policyholders has ture benefit when you first purchase your
caused some companies to get out of policy. Although this benefit will raise
Triggers and the business and has discouraged others your premiums, it will also ensure that if
Elimination Periods from entering. you need to stop paying your premiums
you will receive a paid-up policy from
When your long-term care benefits Risks the insurance company. The revised
start kicking in will depend on two policy will have a lower daily benefit
things: Triggers—the condition(s) that Even if you do purchase long-term or a shortened benefit period, or some
must be present)—and your elimina- care insurance, there will still be risks. other adjustment, but you will still have
tion period. Most obvious is the risk that you will long-term care coverage, depending on
Whether you will need one trigger pay premiums for coverage you never how long you have been paying premi-
or two will depend on your policy. Also, need. Or, you may purchase an amount ums and the cumulative dollar amount
whether care will be administered in a of insurance that does not come close you have paid. Some companies have
nursing home or other facility as op- to covering the significant costs of care. been very slow in paying benefits even
posed to your own home could make There are other risks as well. The after eligibility has been met. That’s
a difference as to what is considered a insurance company may experience fi- another reason why it is important that
trigger. And you will need verification nancial difficulties or, in extreme cases, you review the histories of each service
from a doctor—which could be your even go bankrupt before you claim any provider before making your selection.
own, or the insurance company’s—to benefits. Or you may not need benefits
qualify. Below is a list of common beyond your elimination period, because Conclusion
triggers. you have a long elimination period or a
• Medical Necessity: Sickness or relatively short-term need for long-term There are no perfect solutions. You
injury requires covered care, which care. Not only will you have paid for need to define your risk and determine
must be consistent with accepted premiums without getting benefits, but how much exposure you can live with.
medical standards for treating the you will end up paying the out-of-pocket For certain investors, it would be unwise
sickness or injury. The absence of expenses. (Remember, however, that we to purchase this insurance. For example,
such care would have a negative prefer to pay homeowner’s insurance if you have trouble meeting your exist-
impact on your health. premiums annually and NOT have our ing bills for essential day-to-day living
• Loss of Functional Capacity: You house burn down. Consider the situa- (continued on page 36)

28 AAII Journal
 Insurance Products and Annuities

Life Insurance Cash Value:

A Practical Discussion
By Peter Katt

Article Highlights
• A life insurance policy's cash value is not the same thing as a bank account.
• Borrowing or withdrawing cash values will reduce the death benefit by the same amount.
• Surrender charges show up as the difference between the account value and the cash value.

As readers of my AAII ar- you would reduce the net of your asset
ticles know, I believe the best way (you would own less). This is why a life
to understand the maddeningly insurance policy’s cash value is not, nor
should it be viewed as, a bank account.
complicated life insurance asset
is to present various anecdotes
Unattended Cash Value Loans Can
on specific issues. Crater a Policy
In this spirit, several recent client encounters about aspects
of life insurance cash value has prompted me to discuss cash Stan’s loans accumulated due to a combination of factors.
values—not in a historical and comprehensive sense, but with His agent left the business. When Stan moved, the insur-
narratives to provide a better practical understanding of cash ance company lost track of the correct address to send him
values for owners of life insurance policies. premium notices. As a result, Stan didn’t receive them. Stan
also didn’t pay premiums because he thought the premiums
It’s My Money and I Want It Now were covered within the policy. The premiums were covered
by loans. Due to missed premium notices and the loans, the
A client I will call Stan came to me furious because he policy eventually reached a tipping point of being in danger
was being charged interest on cash value loans from his of lapsing with phantom income within a year.
participating whole life policies. Recently, his agent told him Stan, mistakenly believing that the cash values were his
that without either premium or loan interest payments his to do with as he pleased, then spent hours in discussions and
policies would terminate. Stan was furious because of his written communications with the insurance company trying
insistence that no loan interest be charged, since it was his to pin blame on them for this situation. He threatened legal
money and he viewed the cash balance like a bank account. action. He churned up a lot of frustration. Even if Stan suc-
This isn’t the way life insurance cash value works. Life cessfully proved that the company mismanaged this situation,
insurance as an asset is not dissimilar to, say, apartment the cost in money and time would have produced a huge
units. If you want cash from the apartment asset (or your net loss to him. The amount at stake was really quite small.
life insurance), you take a mortgage (loan) and pay interest. Cash value life insurance with a large loan can cause a
This reduces the net value of the apartment (the life insur- policy to lapse without value, but with taxable income. This
ance death benefits) by the amount of the mortgage (loan). is because the cash value loan value (known in the tax world
Alternatively, you could sell some units (withdraw cash value) as boot) is the gross value of the policy when it lapses. (In
to receive cash. You would not create a mortgage (loan), but this example, the gross value is the loan.) The insurance

January 2014 29
company’s calculation of the cost basis Let’s say a $1 million universal life shouldn’t be done. First, borrowing or
is subtracted from the gross value and (UL) policy has a $100,000 account value withdrawing cash values will reduce the
the difference is the reportable taxable and a $50,000 cash value. The surren- death benefit by the same amount, so
income. Note that when a policy lapses der charge is $50,000. The client could nothing is gained. Secondly, the cash
with no value but with taxable income, borrow or withdraw against the $50,000 value is the foundation of a permanent
there are no funds from the policy to cash value, but not the account value. If current assumption universal life policy
pay the taxes. This is known as phantom the client were to withdraw most of the (as opposed to guaranteed universal life).
income. cash value, the policy could continue for The target premiums are set up to level
I determined that Stan had three quite some time because the monthly the annual cost of the policy with the
choices to rescue the situation, but insurance charges are usually deducted buildup of cash value used to support
only one that was in his best interest. from the account value that would be the increasing cost of insurance charges
Fortunately, Stan has a relatively high approximately $50,000. as insureds get older, with the account
net worth with cash resources. Repay- Let’s say that the client wants to value reducing the amount of actual
ing the loan of approximately $46,000 reduce the policy from $1 million to life insurance.
immediately raises the policy’s cash $500,000. This would cause half of The overall management of a level
value by about an equal amount. It also the $50,000 surrender charge to be in- death benefit universal life policy needs
raises the death benefits from approxi- curred, or $25,000. After the reduction to take into account an insured’s poten-
mately $28,000 to $81,000. Taking into to $500,000, the account value would tial for a change in health so the target
account the payments and the death be $75,000 while the cash value would funding age is accurate. For a healthy
benefit payout at Stan’s life expectancy, remain at $50,000. (The difference be- insured, we need to fund the policy as if
the calculated yield is 3.14% of tax-free tween the account value and the cash he will live to age 100 or beyond—life-
income based on the current dividend. value is the surrender charge, the penalty time funding. Depending on the type of
In the current low fixed-income paid for reducing the policy.) Since the policy, this may mean generating a cash
yield environment, this is a decent return. surrender charges go down each year, value equal to the death benefit at 100.
More to the point, it is the only way for this is a real loss in policy value. In others, we only need $1 to continue
him to have a positive outcome with this The account value offset by the lifetime funding beyond age 100. But
policy. All the other options produce surrender charge is really a way for the if an insured incurs significant health
negative financial outcomes, including insurance company to hide the sales issues, we may decide to fund the policy
repaying the loan and then terminating commissions. If the commissions are to an earlier age, if the probability of
the policy for its surrender value. (Doing lower, the surrender charges are lower living to the earlier age is low because
so would produce significant taxes.) Be- and the surrender cash value is higher. of health issues. The goal is to have $1
cause of his negative feelings generated This can be done on some universal of cash value when the insured dies.
for this insurance company during his life policies (not all) by demanding that This, of course, is a theory and not
long battle, Stan only reluctantly repaid blending be used to replace base death reality, but we can save significant premi-
the loan. Astonishingly, during the long benefits with term insurance. This blend- ums by assessing mortality prospects and
ordeal the insurance company spent ing alters nothing in the policy’s pricing, minimizing the cash value buildup when
most of its time defending its practices. except to reduce the commissions and mortality probabilities are more in favor
To the extent the company suggested surrender charges and increase the cash of dying around, say, age 85 than age
repaying the loan as the only real solu- value. 100. The secret to effective universal life
tion, Stan didn’t accept the suggestion cash value management is not to build
because of his total mistrust. Can I Have My Cake and it up in the first place, because as I’ve
Eat It Too? explained, you can’t get it out without
Account Value Is Not the Same reducing the death benefits.
as Cash Value A client reviewing his annual univer- Guaranteed universal life (ULG) has
sal life statement showing $2.5 million low to zero cash values. Unlike other per-
Almost all universal life policies have cash value for his $10 million policy manent policies that terminate if there is
significant surrender charges that are had a question: Does the cash value add no cash value, guaranteed universal life
listed in the contract. They also show up to the death benefit? He then had an depends on a specified premium being
as the difference between the account epiphany that the answer for his policy paid as contracted for the coverage to
value and cash value in statements and is no. So why not take out most of the remain in force, regardless of zero cash
illustrations. Many clients and advisers cash value? values. 
don’t understand the difference. There are two reasons why this

Peter Katt CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advising firm located near Kalamazoo, Michigan
(269/372-3497); www.peterkatt.com. Find out more about the author at www.aaii.com/authors/peter-katt.

30 AAII Journal
Investment Education in Your Neighborhood
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to-person” social setting. Chapter programming is designed so that AAII members can meet and
learn from the best and brightest investment practitioners.

Visit Your AAII Local Chapter Today

At a chapter meeting, expert speakers show you how to pick winning stocks, analyze mutual
funds, build a diversified portfolio, profit from income investing opportunities and much more.
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and sign up for chapter meeting notices.

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Model Shadow Stock Portfolio:
Purchase Guidelines and Rule Changes
By James B. Cloonan

The Model Shadow Stock longer showing historical figures here in chart
form, although we may mention the number
Portfolio is up 55.6% year-to-
of qualifiers when discussing purchases.
date compared to 29.0% for the
S&P 500 index, as measured
by the Vanguard 500 Index Figure 1. Model Shadow Stock Portfolio vs. Benchmark (Through 11/30/2013)
fund (VFINX). Figure 1 shows
the year-to-date returns as of
November 30, 2013, as well as
annual returns for one-, three-
and 10-year periods.
This has been an exceptional year,
and if the Model Shadow Stock Port-
folio stays at this level it will be the
third-best year in its 21-year history.
As you can see in Table 3, the years
2003 and 2009 were both up over 70%.
Many pundits keep predicting a
pullback. It may happen, but the market
increase has about doubled since the
dire predictions began.
We had been running a chart in this
column showing the number of first-
pass qualifying stocks at my quarterly
review. If the number of stocks passing
my initial screen each quarter had any Year-to- Annual Return (%) Ann'l 3-Year Risk-
Date 1- 3- 10- Std Dev Adjusted
predictive value, the market would have Portfolio Return (%) Year Year Year (%) Return (%)*
fallen six months ago, since very few Model Shadow Stock Portfolio 55.6 61.4 33.8 19.9 20.5 21.9
stocks have been qualifying. Like most Vanguard 500 Index (VFINX) 29.0 30.1 17.6 7.6 12.3 17.6
Vanguard Small Cap Index (NAESX) 34.2 38.3 18.4 10.2 16.4 14.8
possible predictors of future market
direction, it has not shown any mean- *Relative to Vanguard Total Stock Market Index fund (VTSMX).
Data as of 11/30/2013.
ingful guidance. Therefore, we are no

32 AAII Journal
 AAII Model Portfolios

Table 1. The Model Shadow Stock Portfolio

Current 52-Week Market P/E P/B Div

Price High Low Cap Ratio Ratio Yield
Company (Ticker) ($) ($) ($) ($ Mil) (X) (X) (%) Notes
Alamo Group, Inc. (ALG) 58.71 58.95 31.15 709.2 20.9 2.08 0.5
Alpha and Omega Semicon (AOSL) 7.75 9.30 6.64 199.2 nmf 0.70 0.0 earnings probation (2013 Q4)
CSS Industries Inc. (CSS) 31.14 31.94 20.11 288.9 15.7 1.17 1.9
Ducommun Incorporated (DCO) 25.34 30.98 14.32 273.2 15.7 1.13 0.0
Ennis, Inc. (EBF) 18.54 19.59 13.92 486.1 15.3 1.29 3.8
Five Star Quality Care (FVE)* 4.93 6.87 4.44 238.0 18.3 0.77 0.0 qualifed as of 11/30/2013
Flexsteel Industries (FLXS) 27.66 28.10 18.56 198.6 14.6 1.28 2.2
Gilat Satellite Networks (GILT) 4.45 6.20 4.37 187.0 nmf 0.79 0.0 earnings probation (2013 Q3)
Hardinge Inc. (HDNG) 15.49 16.88 9.27 184.1 15.6 1.07 0.5
Hooker Furniture Corp. (HOFT) 17.08 18.31 13.33 183.7 18.6 1.38 2.3
International Shipholding (ISH) 28.31 32.12 15.95 205.2 12.8 0.71 3.5 qualifed as of 11/30/2013
Key Tronic Corporation (KTCC) 10.52 12.28 8.95 110.8 10.8 1.15 0.0
Kimball International (KBALB) 14.89 15.02 8.48 449.1 23.6 1.38 1.3
LMI Aerospace, Inc. (LMIA) 12.69 23.20 10.81 163.1 16.9 0.76 0.0 qualifed as of 11/30/2013
Marlin Business Services (MRLN) 24.85 28.64 15.46 323.2 21.1 1.70 1.8
Medical Action Industries (MDCI) 8.60 10.07 2.53 141.0 nmf 1.46 0.0
Mitcham Industries (MIND) 17.50 18.41 11.51 224.7 30.2 1.27 0.0
Olympic Steel, Inc. (ZEUS) 28.07 31.68 18.10 307.7 nmf 1.04 0.3
PC Connection, Inc. (PCCC) 21.73 22.34 10.00 568.7 16.6 1.78 0.0
PCM Inc. (PCMI) 9.50 11.96 5.66 111.2 13.2 0.89 0.0
RCM Technologies (RCMT) 6.46 6.97 5.00 79.9 17.5 1.27 0.0
Renewable Energy Group (REGI) 11.37 16.50 5.42 414.5 2.9 0.70 0.0
REX American Resources (REX) 32.74 41.00 17.12 267.4 57.4 1.05 0.0
Rocky Brands Inc. (RCKY) 15.24 19.97 12.56 114.6 10.8 0.90 2.6
Salem Communications (SALM) 8.99 10.14 4.97 224.0 nmf 1.14 2.4 earnings probation (2013 Q1)
Shoe Carnival, Inc. (SCVL) 28.93 29.00 18.80 592.8 19.2 1.88 0.8
Standard Motor Products (SMP) 34.72 39.99 19.03 802.3 16.1 2.30 1.3
TravelCenters of America (TA) 10.63 12.50 4.18 314.3 18.3 0.79 0.0
VOXX International (VOXX) 17.84 18.00 6.21 433.2 14.0 0.96 0.0
Willis Lease Finance (WLFC) 18.23 18.24 11.70 153.7 18.2 0.74 0.0

*Company is new to the portfolio as of 12/2/2013.

Source: AAII’s Stock Investor Pro/Thomson Reuters. Data as of 11/30/2013.

Explanation of Notes
Approaching Size Limit: Stocks are sold if their market Earnings Probation: If the last 12 months’ earnings from
capitalization goes above three times the initial maximum continuing operations are negative, the stock is put on proba-
criterion. The current market capitalization maximum for tion; if a subsequent quarter has negative earnings prior to
initial screening is $300 million. Stocks are marked “ap- 12-month earnings becoming positive, the stock is sold. The
proaching size limit” if their current market cap exceeds date within the parentheses lists the fiscal quarter during
2½ times the initial criterion, or $750 million. which the company first reported negative trailing 12-month
earnings.
Approaching Value Limit: Stocks are sold once their
price-to-book-value ratio goes above three times the Qualified as of: Stock still qualified as a buy when the
initial criterion. The current initial price-to-book ceiling is screen was run with current data. Stocks that don’t currently
0.80. Stocks are marked “approaching value limit” if their qualify as a buy are held until they meet one of the sell rules.
current price-to-book-value ratio exceeds 2½ times the
initial criterion, or 2.00.
See the Model Shadow Stock Portfolio area of AAII.com for more information.

January 2014 33
 stock price up dramatically from $4.25 chase, the stock had increased so much
Unusual Activity
to an intraday high of $11.25. Shortly that its price-to-book-value ratio was
There have been only a couple of afterward, short sellers challenged the far above 0.80; based on our rules, it
times in 20 years where dramatic news figures, emphasized the extreme dilution should not have been purchased. If you
came out right after a stock was pur- coming, and questioned the validity of purchased it on the way down when it
chased for the portfolio and before the the sales. (You can go online to Seekin- qualified again (based on questionable
purchase was reported to you. This time, gAlpha.com for the details.) The stock data), I hope our emergency sell mes-
it was Fab Universal Corp. (FU). The price had dropped to $5.50 by the time sage got to you. If it did not, I would
situation with Fab Universal involved we sent out an emergency notice to sell recommend selling it when you can, as
a report of unexpected high earnings on November 20, and a few days later we did in the actual portfolio.
for the quarter with very positive pre- it stopped trading. The story of Fab Universal does
dictions for the future. This drove the By the time we indicated our pur- present an opportunity to review two

Model Shadow Stock Portfolio Rules

Purchase and Sales Rules

Stock purchases must meet these criteria: for a sell. If the bid-ask spread is more than 2%, try to place a
• No bulletin board or pink sheet stocks will be purchased. limit order between the bid and ask prices to keep transaction
• Price-to-book-value ratio must be less than 0.80. If the price-to- costs low. If necessary, build a position gradually. With low com-
book-value ratio moved up a bit since the stock was included in missions, it is often better to place partial orders than to try to
the portfolio, it is still OK to purchase the stock unless this ratio establish a large position all at once. Be patient.
goes above 0.90. (Figure will change gradually with changes in • The average daily dollar volume should be at least four times the
overall market values.) amount needed for your position. This will ensure liquidity to get
• Market capitalization must be between $30 million and $300 in and out of the position, even if you need to grow the position
million. (Figure will change gradually with changes in overall gradually and sell gradually. This will result in a varying number
market values.) of qualifying stocks for each investor.
• The firm’s last quarter and last 12 months’ earnings from • For NASDAQ stocks, it appears to be better to use day orders. If
continuing operations must be positive. the order is not filled, it is placed again with a slight adjustment.
• No financial stocks or limited partnerships will be purchased. For NYSE and Amex stocks, good-till-canceled (GTC) orders are
• No stocks on foreign exchanges or ADRs will be purchased used to keep a place in line in the specialists’ books. If the market
because of different accounting and/or withholding tax on isn’t close to the desired price, the price is adjusted in a few days
dividends. with a new GTC order.
• The share price must be greater than $4. • If price changes cause a stock to become ineligible (due to changes
• In order to reduce trading by avoiding stocks that are forever in price-to-book-value ratio or market capitalization) when only
marginal, any stock that was sold within two years will not be part of the order has been filled, stocks already purchased are
rebought. kept but the balance of the order is canceled.
• Note second item under Stock Order Guidance concerning
spreads when buying shares. Management Rules
• Price-to-sales ratio must be less than 1.2. (Figure may change • Equal dollar amounts are invested in each stock initially.
gradually with changes in overall market values.) • Decisions are made only at the end of each quarter. In order to
• Eliminate any company that failed to file a 10-Q (quarterly) report react to the majority of earnings reports as soon as possible,
in the last six months. quarterly reviews are made in February, May, August, and No-
vember.
Stocks are sold if any of the following occur: • Best judgment is used for tenders or mergers, but all criteria
• If last 12 months’ earnings from continuing operations are nega- must be obeyed.
tive, the stock is put on probation; if a subsequent quarter has • At the end of a quarter, if receipts from stocks sold exceed require-
negative earnings prior to 12-month earnings from continuing ments for new purchases, the excess receipts—up to 5% of the
operations becoming positive, the stock is sold. portfolio’s value—are kept in cash until the next quarter. If the
• The stock’s price-to-book-value ratio goes above three times excess receipts are greater than 5% of the total portfolio value,
the initial criterion. the amount above 5% is distributed to smaller holdings that still
• Market capitalization goes above three times the initial maxi- qualify as buys. Efficient quantities are purchased: If over 10%
mum criterion. of the portfolio is in cash, the price-to-book-value ratio can be
moved up, but never over 0.90.
Stock Order Guidance • At the end of a quarter, if receipts from stock sales are insufficient
• These rules are for general guidance. Your own experience, to buy all newly qualifying stocks, purchases are made in order
market conditions and the size of the position will impact your of lowest bid/ask spreads.
own decisions. The results in the model portfolio were obtained • Note that if you are managing your own portfolio, it should consist
while sometimes paying more. of at least 10 stocks. If you are developing the portfolio gradually,
• Market orders are not used. Instead, if the quoted bid-ask spread you can do it stock by stock, but don’t put more than 10% of
is less than 2% (ask price minus bid price, divided by ask price), your funds in each additional stock. More than 20 stocks is not
place a limit order at the ask price for a buy and at the bid price needed until the portfolio exceeds $1 million.

34 AAII Journal
 AAII Model Portfolios

Table 2. Fourth-Quarter 2013 Transactions some of the stock, is violating one of the buy rules, do
it is acceptable buy not buy it. If it is not clear what the
Company Reason at a price-to-book- impact of the news item (tender offer,
Buy value ratio as high class-action lawsuit, etc.) will be, avoid
Five Star Quality Care, Inc. (FVE) as 0.90). You can the stock. Bad things will occasionally
check the current happen, but they tend to be offset by
Purchased Additional Shares With Excess Cash price-to-book-value unexpected good things and a diversified
LMI Aerospace, Inc. (LMIA) ratio in the Actual portfolio reduces shocks significantly.
Sell Portfolio table at
Addus Homecare Corp. (ADUS) exceeded value limit the Model Shadow Rule Change
Fab Universal Corp. (FU) allegations of fraud & Stock Portfolio page
corporate misconduct on AAII.com, where Due to the impact that the bull
the figures are updat- market is having on the overall market
ed in real time (go to capitalization of stocks, we are increas-
guidelines. www.aaii.com/model-portfolios/stock). ing the maximum market cap buy crite-
First, when we announce a purchase, Second, you should also check the rion to $300 million.
enough AAII members may try to buy news about the stock to make sure a This raises our selling point to
the stock that it moves the price up. This negative earnings or other disqualifying $900 million (three times the initial
tends to even out and a little patience is report did not come out between our maximum) and our warning level to
usually rewarded. But as pointed out in purchase date and the date when you are $750 million (two and a half times the
the portfolio rules, you should not buy buying. Yahoo! Finance (finance.yahoo. initial maximum).
the stock if the price-to-book-value ratio com) or your broker’s website will list
goes higher than 0.80 (if there is a short- such news items. News can push the Portfolio Changes
age of eligible stocks or you already have stock price up or down. If the stock
Table 1 shows the current holdings
Table 3. Model Shadow Stock Portfolio: Annual Performance in the Model Stock Portfolio.
We sold Fab Universal on an emer-
Average Annual Return (%) Cumulative Value of $10,000 ($) gency basis due to uncertainty about
Model Vanguard Vanguard Model Vanguard Vanguard the validity of their data. In the past,
Shadow 500 Small Cap Shadow 500 Small Cap we have eliminated Chinese stocks; in
Stock Index Index Stock Index Index
the future, we will eliminate U.S.-based
Year Portfolio (VFINX) (NAESX) Portfolio (VFINX) (NAESX)
companies whose main business is in
1993 32.3 9.9 18.7 13,230 10,989 11,870 China as well.
1994 2.0 1.2 (0.5) 13,492 11,118 11,810 We also sold Addus Homecare
1995 20.7 37.4 28.7 16,291 15,282 15,204 Corp. (ADUS) because it went over the
1996 22.3 22.9 18.1 19,927 18,775 17,959 price-to-book limit of 2.40 (three times
1997 44.3 33.2 24.6 28,756 25,010 22,375 the initial criterion of 0.80) and is no
1998 (8.9) 28.6 (2.6) 26,188 32,168 21,790 longer a value stock.
1999 (0.0) 21.1 23.1 26,187 38,945 26,831 We bought Five Star Quality Care
2000 (7.7) (9.1) (2.7) 24,163 35,418 26,116 Inc. (FVE) and added to our holding of
2001 21.4 (12.0) 3.1 29,325 31,160 26,926 LMI Aerospace Inc. (LMIA), which still
2002 10.8 (22.1) (20.0) 32,506 24,259 21,535 qualified, because we had excess funds
2003 73.1 28.5 45.6 56,268 31,174 31,360 and did not have enough cash to buy a
2004 43.7 10.8 19.9 80,843 34,530 37,587 full position in September when it was
2005 17.9 4.8 7.4 95,353 36,180 40,376 initially added to the portfolio.
2006 29.4 15.6 15.6 123,363 41,832 46,687 Because of the increase in the
2007 (1.8) 5.4 1.2 121,166 44,083 47,227 permissible market cap to $300 million,
2008 (50.8) (37.0) (36.0) 59,582 27,764 30,217 (raising the sell requirement to $900 mil-
2009 72.3 26.5 36.1 102,665 35,120 41,130 lion), we did not have to sell Standard
2010 45.4 14.9 27.7 149,238 40,358 52,529 Motor Products (SMP) this month.
2011 6.3 2.0 (2.8) 158,701 41,155 51,067 Changes are summarized in Table 2.
2012 33.3 15.8 18.0 211,588 47,666 60,274
YTD 55.6 29.0 34.2 329,136 61,467 80,887
Since Incep 18.2 9.1 10.5 329,136 61,467 80,887 Looking Ahead
Data as of 11/30/2013. As of this writing, we now know

January 2014 35
President Obama’s choice for Federal economy, any hit to the stock market year election cycle average since 1935,
Reserve chairman, and the first reduction should be short-lived, particularly if so I wouldn’t take the cycle indicator
in quantitative easing (the Fed’s bond- earnings continue to be strong. too seriously.
buying program) was announced just The election cycle indicator has been The next column on the Model
before we went to press. Many gurus so far off the mark lately that I hesitate Shadow Stock Portfolio will be in the April
believe the stock market will weaken to even mention it, but the second AAII Journal. In the meantime, you can
with the tapering of quantitative easing year in the cycle (2014) has historically follow updates at AAII.com and through
because of investors switching from been slightly below the overall average the AAII Model Portfolios Update email
stocks to bonds. Given that continued at 11.5%. However, 2013 would have (sign up at www.aaii.com/email).
tapering will depend on a strengthening been up only 6.7% based on the first- Happy New Year! 

James B. Cloonan is founder and chairman of AAII.

Trading Strategies

(continued from page 24) of Dow Theory, “trends exist until a enough to make an early but accurate
pen and that could happen is already definitive signal proves that they have call of a continuation or reversal of an
factored into prices. The markets dis- ended.” Dow Theory advises us to al- established trend? This is where the
count everything. ways assume that the trend is likely to relevancy and weighting of the evidence
Lastly, when performing trend continue until the weight of evidence comes into play, and these are ultimately
analysis it’s important to always be dictates otherwise. The final question, dependent on the experience and abili-
cognizant of one of the main tenets of course, is: How much weight is ties of each individual investor. 

Ray Rondeau is president of the Boston AAII chapter and a member of the Market Technicians Association. Additionally, he is a
former analyst for the website IndexUniverse where he wrote a weekly technical analysis column. For more on the author, go to
www.aaii.com/authors/ray-rondeau.

Insurance Products and Annuities

(continued from page 28)

expenses, adding long-term care insur- publication, chances are you’re interested in a different way than it could—or
ance premiums to the mix would not in investing wisely and having enough frankly should—by not factoring into
be advisable in most cases. money to cover your expenses. Don’t your planning the potential costs of
However, if you’re reading this let the third act of your life play out long-term care. 

Christine S. Fahlund, Ph.D. and CFP, is a senior financial planner and vice president of T. Rowe Price Group, an investment
management firm based in Baltimore, Maryland. Find out more about the author at www.aaii.com/authors/christine-fahlund.
This article is for educational purposes only; it is not intended for investment advice for any individual. Before making an
investment, please consider your personal situation and goals along with your risk tolerance, and read all legal documents
carefully. All material is compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed.

36 AAII Journal
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