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I love small stocks, the smaller the better; small-caps, micro-caps and especially mini-micros, a term I’m using for stocks priced at single-digit levels. This doesn’t mean I’ll buy based solely on a single-digit stock price. Due diligence is always necessary and I’ll discuss that below. But I prefer to hunt and analyze in the lower echelons of the market’s size hierarchy, away from the big well-known issues whose prices are heavily influenced by name recognition, popularity, etc. The lower you go, the more likely it is that you will be able to succeed with garden-variety fundamental analysis, the things you read about in web tutorials, how-to books, seminars, etc.

Here are the two key investment drivers that benefit min-micros.

  1. Very Small Market Capitalizations: There are times when S&P 500 stocks or a broader group of big-caps will lead the market, but over longer time periods, small-caps tend to outperform. This tendency is well recognized by academicians and qants via what’s known as “the small-cap effect.” This is consistent with common sense. For one thing, smaller companies have more room to grow. And beyond that, they tend to be neglected by analysts, institutions and the media not based on ignorance but due to dollars and cents. Institutions invest large sums of money and can’t afford to do the due diligence needed to support positions that will necessarily be too small to have meaningful impacts on overall portfolio performance. Wall Street analysts generally earn their keep by serving institutional investors, so they can’t afford to squander resources covering stocks their clients can’t consider. The financial press earns its keep by attracting eyeballs and ears (which translate to advertising revenue) and, therefore, has considerable incentive to allocate the lion’s share of resources to stocks that more people have heard of and will read up on. Given the diminished level of attention to small stocks, it’s more likely that fundamental merit among this group will not be fully appreciated by the market or reflected in stock prices.
  2. Single-Digit Stock Prices: These stocks constitute an intriguing subset of the small-cap universe based on market culture rather than logic. When single-digit stock prices are mentioned, many immediately think of “penny stocks,” which are associated with lack of tradability and shady ethics on the part of companies and traders. There is a lot of truth to the challenge of tradability, and even in some instances to ethical concerns. The problems tend to be most prevalent among stocks priced below $1.00 that trade in the “pink sheets,” but Wall Street often paints with a broad brush, leading many to shun not just stocks priced below $1.00 but even stocks priced below $10.00. Again, this is not based on logic. It’s entirely possible that a $5.00 stock may be more liquid than a $15.00 stock. But I don’t cause the world to be the way it is; I just live in it and appreciate the way logic lapses can translate to the sort of market inefficiency that facilitates strong investment returns.

By filtering for stocks priced below $10.00, it’s possible I may wind up seeing some mid-caps or even large-caps, depending on how many shares are outstanding. But practically speaking, the overwhelming majority of the stocks I wind up looking at have market capitalizations below $500 million, often well below that level. (Big-cap stocks that appear are often “busted,” making for entirely different, and potentially interesting, situations.) Whether you refer to sub-$500 million market cap as small or micro is up to you; there is no “official” definition. I refer to market caps in that range as micro, and I use the phrase mini-micro to refer to the subset priced below $10.00.

Performance Background

Before moving on to mini-micro stock selection, let’s consider prospects for use of fundamental information to separate winning stocks from losers.

Figure 1 depicts the results of a 3/31/01-4/6/11 performance test of the QVGM (Quality Value Growth Momentum) ranking system I built on the professional Portfolio123.com platform for use there and on the StockScreen123.com individual-investor site. I use it to select among S&P 500 stocks. The light blue vertical bar to the far right depicts the annualized performance of the stocks that rank among the top 20%. The red bar to the far left depicts the annualized share price gain for the S&P 500 index and the dark blue bar next to it depicts stocks ranked in the worst 20%. You can also see all the in-between groupings. (It’s assumed that the lists are reconstituted, based on the latest rank data, every four weeks.)

Figure 1

click to enlarge

That looks OK, albeit imperfect. The best-ranked group of S&P 500 stocks performed best on average and the worst ranked group performed worst. The main flaw, but a tolerable one, is that Group Three beats Group Two by a marginal amount. Notice, too, how all groups performed better than the index itself, suggesting that the standard market cap weighting (more allocation to bigger stocks) has not served the index, or those who track it, well from a performance standpoint, which is consistent with the notion of a small-cap effect. All in all, the QVGM model does appear able to help investors identify the most and least promising investment opportunities within the S&P 500.

Still, we can do better.

Figure 2 shows the results of the same test performed on the stocks included in the small-cap-oriented Russell 2000 index.

Figure 2

When we confine out attention to this group, we continue to see that the best ranked group performs best, etc., but look at the differences. With the S&P 500, the annualized returns of the best and worst groups were about 8% and 2% respectively. With the Russell 2000 group, the best group had an annualized return nearly 16% while the return of the worst group was a bit below 1%. We even see a bit of separation wherein Group Two now outperforms Group Three.

Figure 3 repeats the test on a universe I created for use with my flex mini-micro model (price below 10; eliminate OTC stocks, stocks whose 60-day average daily volume was below 15,000 shares, and stocks classified as Financial Services Miscellaneous, many of which are closed-end mutual funds).

Figure 3

Although the fourth and fifth groups don’t line up exactly in the expected sequence, it’s pretty clear that the QVGM ranking system can be especially useful to investors when we focus on the mini-micro universe. The annualized performance of the best group jumps a bit above 23% while the bottom two groups are more or less in the zero to 1% neighborhood.

A Flex Approach To Mini-micro Stocks

We see from Figure 3 above that the mini-micro segment has a lot of potential winners, as we expect. But don’t be rash: Based on the poor performances of both Groups Four and Five, it also looks like we have a larger percentage of serious losers down here. (The small-cap effect seems to occur not because however many winners it has tends to win big; very, very big.) Also, the typical investor can’t passively choose all stocks in the top-ranked groups. There are nearly 300 selections in Group One, too many for most to cope with. To profit from opportunities in this area, we need to give some thought as to how we’re going to make our individual selections.

This is where the “Flex” characteristic comes into play.

When it comes to identifying promising investment opportunities in general, we’ve all seen and probably created rules; many, many, many rules. We have minimum growth-rate thresholds. We have maximum valuation limits. We have debt requirements. We have margin thresholds. We have rules governing share price trends. Etc., etc., etc. Having once been the primary stock-screening commentator on Reuters.com, having published two books about stock screening, and now being with Portfolio123/StockScreen123, I’m as much into rules as anyone. We see many other Seeking Alpha contributors who also have collections of rules. Many more rules can be found in web tutorials, in the bookstores or at investing seminars. If there is one thing that is absolutely not in short supply in the investment community, it is investing rules.

But, as great as investing rules are (and, by the way, most are quite sensible), we have to be careful in how we fashion them into workable strategies.

Rules-based investing protocols can often seem pretty strict, sometimes even downright macho, as might be the case for a screen that requires, say, ten consecutive years of profitable operation, growth rates above 25% with no down years, PEG ratios below 1.00, expanding margins, zero debt and heavy insider buying. That would be a great collection of characteristics – if you can find it. But with modern stock screening tools being so incredibly powerful, accessible, and easy to use, it’s tempting for investors to ratchet up their demands (and then abandon the screening tool when they find that no stocks pass their screens). It’s especially tempting to be demanding when focusing on the riskier smaller segments of the market.

But pickiness is not as good an idea as it sounds. If you sit around waiting for the perfect stock, you may sit around for a long time invested in nothing. We can wax poetic all we want about holding out for truly great stocks (Morningstar talks about waiting for a “fat pitch”) but conducting investment analysis by sitting on a mountaintop looking down scornfully on humanity is not going to get us far. Bona fide analysis is about coming to grips with reality. The world is imperfect. If you want to be in equities, you have to live with this.

The need to tolerate flaws is especially vital as we move down in size and get into the mini-micro area of the market. Imagine, for example, you’re looking at a piece of artwork created by a third grader. Are you going to evaluate it the same way you would a painting in an art museum? I suppose you could do that – if you don’t mind being alone on holidays because you have no friends and your family wants nothing to do with you. Normal, socially competent, people evaluate things based on criteria that are reasonable in relation to the context.

Stock picking should be approached the same way. These mini-micros are, in a sense, the children of the investment world. We can sit around demanding perfection or assessing them the same way we would a bigger company (a grownup), but doing so is not likely to lead to satisfying results. To invest in mini-micros, we’ll have to shape our strategy around the inherent pros and cons of very small size.

· Cons: (1) These companies aren’t as diversified as larger firms – even a company that appears to be in a single industry can, actually, have a surprisingly large number of different irons in the fire. So when times are tough, bad businesses performance at a mini-micro can’t be as effectively shielded from trouble by better results in other areas. (2) Being small, mini-micros are less able to keep throwing resources at a task, whether it be factory automation, marketing, distribution, etc. (3) Fixed costs tend to loom larger as companies shrink, meaning it’s harder for them to reach and take off beyond break-even levels leading to more volatile profit streams and share price movements. Don’t be shy about looking for narrowing losses in lieu of growing profits. (4) Access to capital markets isn’t always a shoo-in, meaning small firms are more apt to load up on equity when they can (attracting the ire of soapbox pundits who love to scream “dilution” but don’t necessarily think about meeting payrolls in bad times as well as good).

· Pros: (1) Operating leverage, the preponderance of fixed costs, can be a magnificent thing when business is improving, as we see with upside earnings and share price volatility. (2) Ditto the absence of internal diversification; when things go well, overall results aren’t weighed down by struggling corporate cousins. (3) Resources may not be bountiful, but at least the business can benefit from whatever is there, without the aggravation and politics of having to compete with many corporate cousins all of who are likewise salivating over a limited pool of available dollars. (4) Perhaps most important, the smaller the company the less the burden of bureaucracy, which means key managers can spend more time doing and less time explaining (often to corporate functionaries who have little if any understanding of what the business actually is). If you’ve ever worked in a very big company, you know what I mean!

These pros and cons are the main dynamics behind the tendency of smaller stock to outperform large-caps over long time periods, but to do so with more volatility. We see this in Figure 4, a decade-long comparison between the S&P 500 and the Russell 2000 (courtesy of bigcharts.com)

Figure 4

We’ll see below that mini-micros can perform even better than the Russell 2000; considerably better. But if you want to benefit from the aforementioned pros of small companies, we’ll need rules that address the cons, not by brushing them aside and wishing for better numbers but by being flexible and accepting them as inevitable and picking the best of the batch.

There’s one more area where flexibility helps.

What kind of investor are you? Do you cherish value? Perhaps you want growth. Maybe company quality is your thing. Does momentum tickle your fancy? Some great stocks measure up reasonably well under two, three, or perhaps even all of these styles. Others may stand out in one respect but look poor under the others. Still others may be above par, although not necessarily excellent at, say, two of them and pedestrian at the others, or perhaps even dismal in one style.

For a stock, there are many potential pathways to strong performance. Investors, however, often like to choose one path. Many go further and scorn those who favor other paths. Such stylistic passion makes for great bulletin board debates, but can be too limiting when it comes to successful investing. This is why I prefer a multi-style approach, as reflected in the QVGM ranking system and the screen I use to identify potentially appealing for micro-minis.

The screen, flexible in the two respects discussed here, is actually the same one I use for The Forbes Low-Priced Stock Report newsletter. The only difference is that for the newsletter, the maximum price threshold is $3.00. For the micro-mini strategy presented here, the price range is $3.00 - $10.00. In both cases, the preliminary filters (no OTC stocks, average volume, no Financial Services Miscl. Stocks) are as described for the QVGM rank studies described above. Beyond that, here’s how I filter the universe:

  • The stock must exhibit a particular moving-average trend that ranks respectably (not spectacularly or impressively; respectability will suffice) compared to either the universe as a whole or the industry peer group; and
  • The stock must rank respectably (again, I don’t need the best of the best, which will be hard to find given the fixed-cost structures of many mini-micros; respectability will suffice) under one of my Growth-oriented ranking systems; and
  • The stock must demonstrate a decent measure of quality based on one of several standards involving basic profitability, year-to-year growth, or one of my multi-factor Quality-oriented ranking systems.

Among stocks that pass, the top 15, based on the stylistically flexible QVGM ranking system, are selected (subject to a manual review to guard against oddities not apparent in the numbers, which I think is important when we get into this high-risk corner of the market).

Notice that the approach is, indeed, quite lenient. The idea, here, is to rely heavily on the overall performance characteristics of the small-stock universe and try to separate the wheat from the chaff within that group. That’s why there’s such a heavy emphasis on comparison, rather than specific numeric targets. If I were to subtract the performance boost from the small-cap effect and apply the model to a big-cap universe, the lenience would probably lead to results that are mediocre at best.

Figure 5 shows backtested performance form 3/31/01 through 4/6/11 assuming the model (without my manual review) is run and the list of stocks refreshed once every four weeks.

Figure 5

(Note: For me, with the under $3 version of this model, commissions are irrelevant since I trade in my FolioInvesting.com account and I suggest that subscribers who likewise choose to trade the full 15-stock model portfolio use a low-commission arrangement such as that. I also started trading the Flex Micro-Mini model at FolioInvesting.com. I don’t want trading-cost considerations to inhibit me from diversifying to an extent that makes me comfortable, or from swapping out of positions when the model suggests I do that.)

The performance numbers speak for themselves. Like just about every strategy I’ve seen, this one got hammered during the recent crash, but has otherwise beaten the daylights out of the Russell 2000, suggesting that it does, indeed, do a good job separating wheat from chaff within the context of a generally-superior mini-micro universe.

Figure 6 shows the stocks that currently pass muster under the Flex Mini-Micro model.

Figure 6

Stay tuned. In future articles, I plan to update the list regularly and periodically discuss individual stocks.

Disclosure: I am long FFHL, SPAR, JVA, SCLN, AVCA, FVE, FLL, GRRF, PCCC, MALL, MEA, INTT, KLIC, PLAB, NSTC.

Source: My Flexible Mini-Micro Stock Selection Model