In Search Of Small-Cap Growth Stocks That Can Resist Market Volatility

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Includes: AIOTF, ASOMF, CCMMF, FOREY, KYYWF, TFSTF, TSNLF
by: Stockopedia

Recent stock market volatility has been a reminder of the periodic price swings that come with owning equities. But so far, it hasn't been all bad. Look beyond index price charts and you'll find that even at the traditionally sensitive small-cap end of the market, some stock prices have held up well. Often, they were the higher-quality, strong-momentum stocks that are associated with the market's best-known growth investors.

Putting volatility into perspective

There has been a lively debate over the past week about how investors should interpret the recent bout of market volatility. In one exchange, a journalist suggested that investors should "stay alert after the mini-crash". But that was batted away by a fund manager who said a decline of -9.7% on the S&P 500 was "hardly a 'mini-crash'." In fact, the investor (James O'Shaughnessy) argued that the real anomaly was the relentless, low-volatility uptrend in U.S. markets last year. He said what we'd just witnessed was really just "par for the course".

To be fair, UK markets didn't give us quite the same sort of smooth, decent, double-digit gains as the S&P 500 and Nasdaq last year. But one exception was the 25 percent return from the Alternative Investment Market. The smaller company growth market had an excellent run in 2017, helped by some big gains from some of its biggest companies.

This was great news, of course, for investors wanting to take advantage of AIM's attractive tax status. Not only can most of its smaller, high-growth companies be added to ISAs, but most (not all) can be passed on free of inheritance tax, subject to certain rules.

The downside of all this is that AIM companies have often tended to be sold off quite aggressively in a downturn. That's why small-cap investing generally comes with a warning to ensure adequate diversification. Since the start of February, the index has fallen by a modest 4.5 percent overall - but many stocks have actually held up well. So what were they?

Small-cap growth strategies

There are numerous investment strategies that have proven to be effective in a small-cap market like AIM. Stockopedia's Paul Scott and Graham Neary have shown just how profitable the market can be. Other high-profile small-cap investors and fund managers over the years include the likes of Mark Slater (and his late father, Jim), Gervais Williams, Robbie Burns and Giles Hargreave. All of them combine a focus on growth, quality, value and momentum.

Hargreave once explained to me: "It's just so obvious that with a small company you can make money a lot faster in percentage terms than with a big company - you've got a real chance. You can buy stocks that go up three or four times quite quickly, but you're unlikely to do it with larger FTSE stocks."

Over the past five years, his flagship Marlborough Special Situations fund has generated a near-118 percent return. Part of that success is down to the way it deals with the risky nature of small companies - the fund holds as many as 200 stocks, and sometimes more. By doing that, it aims for relatively low volatility and relatively good performance.

But the other aspect of Hargreave's approach is his focus on buying the best companies AIM has to offer. So he arguably runs a classic high-growth strategy, which would look something like this:

  • Positive earnings per share (EPS) that have been growing by more than 10% compounded over three and five years.
  • Return on Capital of more than 12%.
  • Net Margins are increasing year on year.
  • Positive relative price strength.
  • A constituent of the FTSE SmallCap or AIM All-Share index.

Here are some of the companies that are currently passing those rules:

Name

Mkt Cap £m

P/E Ratio

EPS 3y CAGR pc

EPS 5y CAGR pc

PEG Rolling

1-Month Relative Price Strength

Gama Aviation

112.2

7.6

32.0

20.1

1.0

+16.0

LPA

20.7

11.3

44.6

18.8

-

+11.1

Amino Technologies (OTC:AIOTF)

142.8

14.2

21.0

20.7

3.1

+10.3

ASOS (OTCPK:ASOMF)

5,831

90.5

22.7

45.3

3.2

+9.3

Numis

357.6

12.8

14.8

54.4

2.8

+8.6

Keywords Studios (OTC:KYYWF)

915.7

108.3

43.6

18.6

1.0

+7.9

Tristel (OTC:TSNLF)

109.6

32.2

34.7

30.7

3.1

+7.0

CMC Markets (LSE)(OTC:CCMMF)

443.1

8.4

16.4

69.9

-

+7.0

Trifast (LSE) (OTC:TFSTF)

296.7

21.1

21.2

27.4

3.4

+6.3

4imprint (LSE) (OTCPK:FOREY)

533.6

26.4

34.1

39.5

1.3

+5.8

Regardless of the strategy, not all companies are going to resist market downturns - and some will inevitably be hit by selling pressure. But over the past month, these stocks have resisted the market trend, which is encouraging considering their average size. This list includes some well-known success stories - such as ASOS and Keyword Studios - and the high valuations in places do reflect that.

Overall, these companies all have a track record of compounding earnings growth over the medium term. And their share price strength in the market over the past month suggests that many have held up well against the volatility.

When I interviewed him, Hargreave said that a key to his fund's success is that it gets more right than wrong, and when they do go wrong, he tends to get rid of them. His focus is very much on running winners and selling losers.

For individual investors, the focus on quality and diversification in small-caps with the potential for large and rapid gains is an investment template that could be worth taking further. Smaller companies can be unpredictable, and careful research is essential. But in the right areas of the market, the returns can be impressive, and these stocks can be pretty resilient to turbulence.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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