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It is quite likely that the far majority of Seeking Alpha readers are longer-term investors. That being said, even long-term investors engage in some speculative trading from time to time with a small portion of their capital. If trading tiny volatile stocks with very small amounts of money is something that appeals to you… you might be interested in a small caps trading system I developed and what drives it.

Rationalizing Small Caps Trading and Risks

If you are looking to invest in small caps, you can do so by purchasing a broad ETF such as the S&P 600 Small Caps SPDR (SLY). Over long periods of time it does appear that smaller stocks do outperform slightly.

(click to enlarge)

Some prefer to try selecting stocks on their own as they attempt to stock-pick - or increase their odds of holding a winner instead of buying a broad base of small-cap stocks. But before you run out and buy micro-cap stocks, you should realize that there are risks with owning these companies.

  1. Liquidity is a common issue in these smaller offerings. Buying into companies with little volume can give you a poor average price when buying and selling unless you are patient and are willing to build your large position over time. Liquidity may be decent when you enter the stock (especially if buying around earnings or some other event), but it may dry up when you want to sell.
  2. Other risks include the company's lack of financial backing, which may lead to higher attrition during periods of economic woe.
  3. As well, analysts typically give these smaller stocks less coverage than well-known brands. A lack of information is another form of risk.

But as Angel Investors and Venture Capitalists know, it only takes a few smashing success stories to provide lift to a hum-drum portfolio…if you are willing to get your hands dirty by screening potential candidates and have an exit strategy. While I don't claim to have a "one size fits all" system, I do believe that I have combined a few catalysts that may work for some investors.

Small Caps Fiscal Momentum

This small caps system is based on the Small Caps Fiscal Momentum portfolio. What are the underlying forces that drive this basket trading strategy? I will break the system into two parts - stocks and trading catalysts.

Stock Universe

I separate stocks for the catalysts since one simply dictates the type of stock to buy while a catalyst is what provides the timing. In the paper, Size, Value, and Momentum in International Stock Returns (Fama, French 2011), the evidence points toward outperformance of small-value stocks. The chart shows how market cap and book to market ratios affect monthly performance.

(click to enlarge)

The x-axis goes from small to big market cap and the y-axis goes from low value to deep (high) value. The upper right corner shows that small-value stocks out-perform the one-month T-bill rate by 0.44% on average between the November 1990 and March 2011. Remember that these are monthly performance figures.

My investable universe for the Smallcap Fiscal Momentum strategy goes a little beyond the above although it holds to the small/value principle. I rank stocks based on a variety of value factors such as the following:

  • Price to earnings
  • Forward PE
  • PEG
  • Price to sales
  • Price to free cash flow
  • Price to book ratios

While I favor small stocks, I ensure that there is at least $100,000 trading in the stock daily - at least at the time it is purchased.

Running a quick scan with 3 month re-balancing we get the following results over the past 10 years (screening for deep value, over $100,000 daily total, bottom half of market cap, price per share above 50 cents, and stocks need to report some financials for fundamental ranking which excludes many on the OTC exchanges).

Statistics

Total Return

Annualized Return

Max Drawdown

Sharpe Ratio

Sortino Ratio

Standard Deviation

Correlation with
Benchmark

R-Squared

Beta

Alpha

Screen

383.23%

17.06%

-73.81%

0.48

0.59

27.87%

0.62

0.38

0.91

12.21%

S&P 500

54.79%

4.46%

-56.26%

0.04

0.05

18.79%

-

-

-

-

(click to enlarge)

Of course, this is not yet a usable strategy but it gives us an indication of how the investable universe has performed over the past 10 years.

Trading Catalysts

But when do we buy and when do we sell? I primarily use fundamental analysis in all of my model portfolios and this one is no different. Now that we have a group of deep value stocks with smaller than average market cap, it is time to find triggers that may lead to a quick rise.

  1. Increasing earnings estimates. Various white papers have pointed to the phenomenon of investor under-reaction to early forecast revisions. It may well be that investors are waiting for actual earnings announcements, higher profile analysts such as Cramer to report on the stock, or for more analysts to chime in positively before investing. One early catalyst is to screen for a positive change in the annual earnings estimate.
  2. Earnings surprises. Whether or not this is simply added risk or an all-around better return, there is a phenomenon where stocks drift upwards for a time after an earnings surprise.
  3. Price momentum. Stocks that out-perform over the past 3, 6 or 12 months generally do so over the succeeding 12 months.

Stocks are sold when either value or trading catalyst ranking drops or when earnings are revised lower than the week before. The buy signal can be a combination of any of these three major catalysts, or it could be unusual strength from a dozen or so other factors screened for such as improving margins.

Shaping the System

In addition to these rules that I consider to be more or less timeless, there are other rules that I use to shape the system to lower risk or increase upside gain - which is based more on past history than any universal investing principle.

  1. For risk, I have a rule that only allows me to purchase more shares when the S&P 500 current year EPS estimate is trending upward or if the S&P 500 (SPY) share price is above its 100-day moving average. This rule does not affect selling.
  2. My other rule makes this portfolio focus heavily on Healthcare and Consumer Discretionary sectors. It may be that the cyclical nature of Consumer Discretionary and the potential for big surprises in pharma stocks in the Healthcare sector works well with this system, or it may just be an anomaly that will gradually fall to other sector averages. For the time being I am using this because it works.

The Last 3 Trades

Below are the last 3 recommended buy trades. Keep in mind that this quantitative system is programmed and run mechanically although the trades are executed manually. These were the trades recommended by the system:

  1. On October 22nd the stock K-Swiss Inc. (KSWS) was recommended as a buy. It seemed that the signal was picked up before the November1, earnings announcement. This gave a $2.50 buy recommendation. This is still a recommended holding. Clients following the recommendation would have a 24.4% return so far.
  2. Stanley Furniture Co. Inc (STLY) was recommended on October 29, (but you would have to wait for market to open two days later) for an entry price of around $4.63 per share. Clients following the recommendation would have a 0.86% return so far.
  3. The most recent recommendation was to buy Standard Motor Products Inc. (SMP) on November 5, with an opening price of $19.18 - $19.25. After one day of trading the price is up modestly to $19.72. Clients following the recommendation would have a 2.7% return so far.

How has this system turned out over the past 10 years? I ran the parameters though a fundamental strategy back-testing service that I frequently use and factored in 0.5% slippage on every trade with $4 per transaction. Even then, this would only be suitable in very small amounts of capital… perhaps $5K or $10K per stock and it goes without saying that you would be using limit orders. Here are the stats over the trailing 10 years:

Quick Stats as of 11/6/2012

Total Return

6,154.25%

Benchmark Return

53.42%

Active Return

6,100.83%

Annualized Return

51.20%

Annual Turnover

643.99%

Max Drawdown

-39.27%

Benchmark Max Drawdown

-56.78%

Overall Winners

(356/727) 48.97%

Sharpe Ratio

1.33

Correlation with S&P 500

0.46

Why do I use the term "clients following the trades" when discussing the last 3 trades? Because although this portfolio keeps running through good times and bad, we recently recommended investors focus on the defensive, dividend growth, dividend value, and various ETF strategies as the markets turned shaky instead of this small-cap system that is far more volatile. When the market turns upward, this system performs best.

Source: Small-Cap Stocks: My Top Trading Strategy

Additional disclosure: I currently have no positions in these stocks due to the higher downside potential of smallcaps in this choppy market but may trade when market timing recommends. These are the actual recommendations of the SMALLCAPS FISCAL MOMENTUM portfolio by Portfolio-Cafe that I am authorized to disclose.