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One effect of the rally is finding profitable, exchange-listed micro-cap stocks that are still trading at low valuations. This is a challenge facing AAII members who follow our Model Shadow Stock Portfolio. This portfolio uses strict rules for purchase, including a maximum price-to-book (P/B) ratio of 0.8, a maximum price-to-sales ratio of 1.2 and a maximum market capitalization of $300 million. The portfolio rules also include restrictions regarding profitability, minimum share prices, exchange listing and company characteristics.

I will share with you the logic behind our rules and the adjustments we suggest to AAII members seeking to follow the approach to give you an idea of how you could adjust your approach to micro-cap stocks.

Our P/B rule is based on upon highly regarded academic research showing that aggregate groups of stocks with low P/B ratios outperformed groups of stocks with high P/B ratios. The best-performing group had a P/B ratio among the lowest 10% (decile) of NYSE-listed stocks. The Shadow Stock portfolio's P/B rule roughly corresponds to the lowest decile, and we adjust it upward and downward over time to reflect prevailing market valuations.

Our cap on market capitalization is based on academic research showing a size premium. Over the long term, performance is inversely related to size, with small-cap stocks outperforming large-cap stocks. The size restriction also is designed to exploit a key advantage individual investors have over institutional investors: the ability to go into the shadows of the market. Institutional investors are generally forced to avoid micro-cap stocks because there is not enough liquidity to buy them in meaningful amounts or sell large quantities quickly without moving the share price. Hedge funds also generally avoid these stocks because the low level of liquidity makes it costly to trade them frequently. Individual investors who are willing to follow a buy-and-hold approach, conversely, do not incur these problems.

The objective of the Shadow Stock approach is to construct a portfolio from the 1% of stocks that has both a low price-to-book value and a low market cap. These stocks carry higher spreads and should not be traded, but rather bought and held. Much of the Shadow Stock portfolio's success, including its 61% gain last year, comes from its low levels of turnover.

Even with the aforementioned restrictions, in a typical month there are at least a few stocks within the portfolio that qualify for purchase under our rules. This month is not a typical month, however, and no stocks currently qualify under a strict interpretation of the rules.

Investing is messy, however, and there are technicalities investors can consider. AAII founder and chairman Jim Cloonan, who runs the portfolio, says if there is a shortage of eligible stocks, the maximum price-to-book (P/B) rule can be relaxed from 0.80 to 0.90. You could even increase it to 0.92. Under this looser standard, LMI Aerospace (NASDAQ:LMIA) and Rocky Brands (NASDAQ:RCKY) qualify as buys. As of Thursday, LMI Aerospace traded at a P/B of 0.84 and Rocky Brands traded at a P/B of 0.86.

The other technicality is to not require earnings to be positive for the last reported quarter. The rationale for doing so is to open for consideration companies with either one bad quarter or repeating seasonal factors. Loosening this rule would qualify International Shipholding (NYSE:ISH) and Willis Lease Financial Corp. (NASDAQ:WLFC) for purchase, which trade with P/B ratios of 0.61 and 0.72, respectively. If you choose to invoke this technicality, use extra scrutiny to ensure one bad quarter does not turn into several bad quarters or a full 12-month period of negative earnings. Shadow Stocks with two consecutive quarters of negative 12-month earnings from continuing operations are sold.

Regardless of how you choose to approach micro-cap stocks or use any other strategy, adhere to a disciplined method of implementing it. Follow the rules and do not violate the spirit of the strategy. Mr. Market will tempt you to do otherwise, but success comes in part from developing and sticking to a well-defined and consistent approach.

Source: Tweaking A Value Approach To Micro-Cap Stocks

Additional disclosure: AAII also holds all four of the stocks mentioned in this article in the Model Shadow Stock Portfolio.