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?
- AGP is making a low volume shake-out that should with a good entry around $57 - $58 if accompanied with a spike in volume
- CBM is in runaway mode on high volume. If you are a momentum investor this might be right up your alley
- 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
- ENSG is making a decent short-term advance after bouncing on $20 support in August and Sept
- GB is another stock that is struggling being above $19 support
- HMA went down hard lately and I’d like to see a little more positive action before recommending a buy
- HSKA is channeling downwards in a negative way. Some support exists at $6 and I would definitely wait on this one
- 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
- LPNT is sitting on support and consolidating after a healthy run up. I’d wait for some further positive action on this one
- 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
- 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
- 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.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
