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What can an investor do if he wants the upside potential of small-caps but the defensive properties of lower risk investments? One tactic is to trade tiny companies in a defensive sector. While I wrote about a similar defensive healthcare strategy a few weeks ago, this one is focused on the smaller companies for potentially higher excess gains or it can also be used as a portfolio diversification tool.

Small-Cap Healthcare Stock Screening

With our small-cap healthcare stock screen, we will target deep value. To do so we will make use of a value ranking system (compliments of Portfolio123) that ranks stocks based on the following:

  • Lower trailing and forward P/E ratios
  • Lower PEG ratios
  • Lower price to sales and price to free cash flow and price to book ratios

We keep the highest 20% ranked value stocks based on the above criteria. We also add in a few rules for liquidity such as share prices more than $1, daily volume more than 50,000 shares, a USA company, and upwards revised earnings estimates (for the current fiscal year) over the past 8 weeks. Of course, to make sure we have small-cap stocks we won’t be trading anything over $3 billion in market capitalization.

Backtesting Our Defensive Healthcare Strategy

The principles seem to be sound and simple. We are targeting smaller stocks in what we feel is a defensive sector. We want the best value possible and enough liquidity that we don’t get consumed in slippage costs. Our strategy will be to screen and hold for 3 months, following which we re-screen and re-balance to hold a maximum of 15 companies.

Has this been a profitable trading strategy over the past 10 years?

*This is a scan is available for public use under the name ‘Hemmerling Healthcare USA’ on Portfolio123

Our initial test shows an incredibly high compound annual growth rate of 31.04%. Is this some anomaly from ‘accidentally’ picking the perfect entry? We test this with a robustness check that will randomly buy and hold for 3 months – and we will do this over 550 times over the past 10 years to compare average results.

  • The average 3 month holding gain is 6.27%
  • Compound this quarterly for an annualized gain of 27.54%

While the robustness check shows our annualized gain to be a little lower than we initially thought, it still retains significant gain for a defensive sector.

Analyzing Previous Picks

To get a feel for how this strategy works, let’s look at a few stocks during the 3 month trading window that showed up on this scan from December 20th 2010 to March 21st, 2011. The S&P 500 (SPY) rose 4.1% during this snapshot in time.

Running the 'Hemmerling Healthcare USA' scan produced the stocks listed below. They are ordered according to the 3 month price gain or loss.

Ticker

Name

Start

End

Gain/Loss

MktCap

(SKH)

Skilled Healthcare Group, Inc.

8.63

12.83

48.67

324.23

(HWAY)

Healthways, Inc.

11.04

15.38

39.31

378.46

(MATK)

Martek Biosciences Corp.*

23.22

31.54

35.83

770.72

(AGP)

AMERIGROUP Corporation

46.16

60.64

31.37

2285.34

(ENSG)

The Ensign Group, Inc.

23.72

30.56

28.84

488.33

(KCI)

Kinetic Concepts, Inc.

41.61

52.84

26.99

2972.57

(OCR)

Omnicare, Inc.

24.56

29.14

18.65

2840.74

(HGR)

Hanger Orthopedic Group, Inc.

21.62

25.18

16.47

698.34

(GTIV)

Gentiva Health Services, Inc.

25.79

27.98

8.49

769.89

(SUNH)

Sun Healthcare Group Inc

12.33

13.36

8.35

311.43

(LPNT)

LifePoint Hospitals, Inc.

37.17

39.45

6.13

1955.76

(TFX)

Teleflex Incorporated

55.59

57.27

3.02

2223.89

(MGLN)

Magellan Health Services, Inc.

47.41

46.73

-1.43

1589.98

(AFAM)

Almost Family, Inc.

37.56

36.5

-2.82

344.87

(MDF)

Metropolitan Health Networks, Inc.

4.82

4.51

-6.43

194.15

Let’s look at our highest and lowest earning picks to see what we can learn:

Skilled Healthcare Group (SKH) – On November 1st the earnings and revenue were revised upwards and a press release on January 6th gave a further positive earnings revision. The quarterly reports for December 2010 and March 2011 both held double digit earnings surprises. Some studies have linked upwards drifting prices for a few weeks following an earnings surprise. We screened for upward revisions and it paid off with a 3 month gain of almost 50%.

Metropolitan Health Networks, Inc. (MDF) – This could have been a decent trade if we actively managed our stocks instead of holding for 3 months regardless of how the stock performed. A small market cap of a only a couple hundred million (at the time) is more volatile and sensitive to such things like insider selling on March 7th - 9th as $850,000 worth of stock was dumped. If investors thought this was signaling poor future earnings, they would be mistaken when a 35% earnings surprise came out two months later. It was bad timing on our part but the shares are now nearing $8 a piece.

What we learn is that while stock screening and regular re-balancing might be useful to incorporate into a strategy, we still need to follow the news and earnings reports. Having your eye set on some support and resistance levels for exits would be prudent as well.

Current Small-Cap Healthcare Stock Picks

Ticker

Name

Last

MktCap

(CYH)

Community Health Systems

17.62

1728.54

(KND)

Kindred Healthcare, Inc.

11.8

666.11

(SUNH)

Sun Healthcare Group Inc

3

508.83

(LPNT)

LifePoint Hospitals, Inc.

37.29

1868.88

(SEM)

Select Medical Holdings Corporation

8.33

1285.58

(GB)

Greatbatch Inc.

20.76

509.05

(HSKA)

Heska Corporation

6.93

35.73

(THC)

Tenet Healthcare Corporation

4.44

2263.19

(MGLN)

Magellan Health Services, Inc.

47.43

1420

(AGP)

AMERIGROUP Corporation

54.7

2752.98

(HMA)

Health Management Associates, Inc.

7.35

1971.84

(SKH)

Skilled Healthcare Group, Inc.

4.61

178.66

(CBM)

Cambrex Corporation

7.12

211.13

(CHE)

Chemed Corporation

49.55

1016.54

(ENSG)

The Ensign Group, Inc.

23.85

521.07

We timed our entry and exit poorly in Metropolitan Health Networks. To rectify that in the current picks, what are some features on a price and volume chart we should consider?

  1. AGP is making a low volume shake-out that should with a good entry around $57 - $58 if accompanied with a spike in volume
  2. CBM is in runaway mode on high volume. If you are a momentum investor this might be right up your alley
  3. CYH is trading down quite hard at is sitting on support of $17.50. I’m more of a ‘wait and see’ kinda guy than a ‘it can’t go any lower’ investor
  4. ENSG is making a decent short-term advance after bouncing on $20 support in August and Sept
  5. GB is another stock that is struggling being above $19 support
  6. HMA went down hard lately and I’d like to see a little more positive action before recommending a buy
  7. HSKA is channeling downwards in a negative way. Some support exists at $6 and I would definitely wait on this one
  8. KND has been making a very strong advance since October. It looks like it may be ready for another small bounce in a couple of days
  9. LPNT is sitting on support and consolidating after a healthy run up. I’d wait for some further positive action on this one
  10. MGLN is sitting on a trendline fence – so to speak. While the timing looks OK, I’d wait a couple of days to see some strength first. Some recent heavy selling is a warning flag for me
  11. SEM has rocket up from the mid $5 range back in August. I’d prefer to see it pop above $9 (and stronger resistance at $9.50) before jumping aboard
  12. SKH, SUNH and THC are trading low based on the annual price highs, but they are making a valiant attempt upwards over the past couple of months

If you have any other thoughts to improve this ‘Hemmerling Healthcare USA’ small-cap screen, or you’d like to see an additional fundamental or technical filter, I’d like to hear about it in the comments section below.

Source: 15 Small-Cap Rockets In An Unexpected Sector