No 'Fooling' Around With This Top Performing Small Cap Growth Stock Model

by: John P. Reese

Small cap stocks offer investors lots of long term opportunity, but finding a way to filter out the best stocks is how long term alpha be achieved.

We've captured a small cap growth model that combines quality, with momentum & growth to find names with the potential for outperformance.

Our portfolio based on this method is the top performer with a high degree of consistency. We've identified a few names highly rated at the current time.

When you buy shares of big, well-known companies, you're swimming with the sharks. At least that's the opinion of David and Tom Gardner, brothers and co-founders of the multi-media financial services company The Motley Fool. They argue that Wall Street (and analysts) devote a lot of time and attention to these companies and that individual investors are therefore unlikely to uncover something everyone else has missed. Small-cap stocks, on the other hand, are described on their site as "a deserted lagoon" many of which are "pearls of potential profit, waiting for the right catalyst to value them into the limelight." Although they tend to suffer deeper dips than their larger counterparts, the Gardners argue that small-caps can offer huge upside.

The Motley Fool, in part, specializes in searching out stocks of small, fast-growing companies with solid fundamentals, including healthy profit margins, low debt, ample cash flow, respectable R&D budgets and tight inventory controls. A key indicator of a strong stock, they believe, is an earnings growth rate that is greater than the stock's price/ earnings ratio. Wall Street calls this metric the PEG ratio (price/earnings-to-growth ratio); the Gardners call it the Fool Ratio. By either name, it's a great way to separate attractively valued growth stocks from those that are overvalued.

Small caps tend to outperform, says The Motley Fool, for the following reasons:

  • They fly under the radar: Wall Street is dominated by institutional investors with "boatloads of money; they can't invest in smaller companies without driving up the price" and, since mutual funds face restrictions regarding how much they can invest in single companies, smaller companies are often overlooked.
  • Small-caps tend to grow more quickly. Since smaller companies are working from smaller revenue bases, they can sustain strong growth for longer periods of time. Bigger businesses, on the other hand, can take a long time to achieve dramatic top-line growth.
  • Although small-cap companies are often startups with less-experienced management and limited access to capital, over the long run they can offer significant returns.

An article posted last year in ETF Trends last year outlines the following advantages associated with small-cap investing:

  • Over long periods, small caps have outperformed large caps.
  • Small caps have a history of recovering quickly after downturns. The article argues that the asset class "bounced back more than twice as fast as large caps after the tech crash in the early 2000s, and 14 months faster than large caps following the credit crisis in 2008."
  • Since small caps are more domestically concentrated, they are less exposed to global events and currency risks.
  • Rising interest rates are less impactful to small caps because they typically have lower debt levels than large caps.

Validea used the investment strategy outlined in the Gardner brothers' book The Motley Fool Investment Guide to create our Small-Cap Growth Investor model. In order to pass this screen, a company must meet the following criteria:

  • Trailing 12-month after-tax profit margins must be at least 7%, and stable margins over the prior three years (or, ideally, consistent growing margins);
  • Relative strength of at least 90;
  • Both revenue and near earnings growth of at least 25% compared to the prior year;
  • Insider holdings of at least 10%;
  • Positive operating cash flow;
  • "Fool" ratio (ratio of price-earnings to growth in earnings-per-share) of between 0.5 and 0.65;
  • Low leverage

Our Motley Fool-based portfolio has outperformed the market in 12 of the 15 years since its inception in 2003. While last year it trailed the market by nearly 20% (its worst year yet), this year the portfolio is up 17% versus flat performance for the market. Below is the long term performance of the model since 2003, as well as the year-by-year returns below.

Validea TMF Returns Using our stock screening model inspired by the strategy of The Motley Fool, I have identified the following five high-scoring stocks:

Johnson Outdoors Inc. (JOUT) is a manufacturer and marketer of branded seasonal, outdoor recreation products that operates through four segments: Marine Electronics, Outdoor Equipment, Watercraft and Diving. The company scores well based on its profit margin of 8.64%, insider holdings (17.78%) and debt-free balance sheet. Free cash flow-per-share of $3.14 adds interest.

Noah Holdings Limited (NOAH) is a wealth management service provider with a focus on global wealth investment and asset allocation services for high net worth individuals and enterprises in China. The company's relative strength of 95 earns high marks, as does its after-tax profit margin of 23.69% (versus the minimum requirement of 7%). Insider holdings of 57.39% are a plus.

ETrade Financial Corp. (ETFC) is a financial services company that provides online brokerage and related products and services primarily to individual retail investors under the brand E*TRADE Financial. With relative strength of 92 and a 29% after-tax profit margin, the company earns high marks from our Motley Fool-inspired screen.

Planet Fitness Inc. (PLNT) is a franchisor of fitness centers in the U.S. with relative strength of 92, and increasing profit margins over the past few years. The company's positive free cash flow is also a positive.

RMR Group Inc. (RMR), through its subsidiaries, manages a portfolio of publicly owned real estate and real estate-related businesses. The company's operating cash flow ($6.79 per share) scores well, as does its consistently growing profit margin over the past three years.

Disclosure: I am/we are long JOUT, ETFC & RMR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.