Small-Cap Growth: Analyst Coverage Discount?

One of my favorite sources of new ideas is a screen that I run on StockVal. In fact, I publish a monthly report, the Small-Cap Rocket Report, in which I give a brief synopsis of the names that meet the criteria. If you click on the link, you can download a copy and see all of the parameters that I employ. The goal is to identify Small-Cap stocks with high ROIC, good price momentum, stable or rising estimates, a good balance sheet, reasonable valuation and a relative lack of analyst coverage. It’s a lot to ask for! Usually 10-15 names make the list. Here is the output from October 5^th:

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Often I run across names in other screens that would most likely make the list if it weren’t for the high number of analysts covering them. I decided to run the exact same screen, but to include only those names with analyst coverage in excess of the limit that I usually impose. Here are the results:

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Each of the lists is in alphabetical order. A couple of the “highly covered” members, VDSI and WHQ, were formerly “undercovered” earlier this year. The two groups have some similarities in terms of representing several different economic sectors and having strong balance sheets, but one thing really stands out: the PE differential. The “undercovered” group has a median of 22.9 compared to 29.4 for the “highly covered” group. While the PEG ratios are closer, that calculation begs the question of accuracy of the long-term growth rates, especially in situations where there are few analysts. As analysts aren’t “graded” on these numbers, many don’t put a lot of thought into them. Of course, the smaller the sample, the less accurate the number would be.

My hypothesis is that as the companies become better followed, the rapid growth that they have experienced results in higher growth expectations. Just looking at the two that I mentioned as having added analyst coverage, I would note that the VDSI GRE has increased from 25 earlier this year to 32.5, while WHQ has been pretty stable. In any event, my expectation is that as the “undercovered” names receive more coverage, they could enjoy PE expansion. Given the high underlying growth rates for these companies, those that do see their valuation metrics increase will deliver very high returns over the next 6-12 months. I could have it all wrong in terms of the cause of the value discrepancy. Perhaps investors are just willing to pay more for companies with more coverage (or are more exposed to the names). In any event, I will keep hunting in what I believe are the fertile grounds of relatively obscure Small-Cap Growth stocks.

Comments

[Uncle BIM]

Well writen with brevity. Two thumbs up!

[Uncle BIM]

Well writen with brevity. Two thumbs up!

[bondinvestor]

Alan, the analyst optimism in WHQ would appear to be misplaced, at least in the short term, after the pre-announcement and lower guidance for the company. Your screen might be improved if a sell discipline was built. Maybe there's a "critical mass" of analysts at which excessive optimism is sure to result in underperformance. Given there's a finite number of sell-side firms with any real power over sentiment, there might be a trigger to sell when all the bulge-bracket firms cover a stock. (Note that I'm *not* suggesting that smaller-firm sell-side or independent analysts can't be more "right" than the big boys, just that they by definition they reach fewer people who actually follow their advice (blindly or not).

[AlanBrochstein]

That's a good point. I do tend to use high analyst ratings as a negative input, though WHQ didn't really have such strong opinion behind it. I think that there is a persistent investment arbitrage potential in buying the names that aren't so recognized and trading them out potentially when they become recognized.