3 Tips To Generate Alpha In Smaller Stocks

|
Includes: AAPL, ACRE, AJX, AMNF, AMZN, ATAX, BCBP, CORR, CZNC, EFSI, ENBP, FDUS, FMBM, GAIN, IOFB, JCAP, JNJ, KISB, KO, LCNB, LSBK, MFNC, NASB, OTTW, PFOH, QNBC, SPY, SWSSF, TAIT, TBNK, TPVG, VABK, WSBF, XAN
by: Kurtis Hemmerling
Summary

Alpha is abundant in smaller stocks.

Stocks of lower liquidity are more suitable for the retail investor.

I provide 3 'tried and true' tips to find small stocks with a high likelihood of out-performance.

Stocks with a tiny market capitalization trading with low liquidity is where alpha lives and breeds. This isn’t just my viewpoint – it is a well-documented fact. The 2018 white paper, Replicating Anomalies, highlighted this finding:

Microcaps have the highest equal-weighted returns and the largest cross-sectional dispersions in returns and in anomaly variables."

The key for me is the last part pertaining to anomalies. As a quantitative researcher that digs deep for anomalies, I know of no other area in the market with higher potential for market-beating returns. But be forewarned, blindly buying small stocks is no recipe for success. It is full of landmines and traps. There are so many stocks to look through and so little information.

Consider the total return of very small stocks (less than $500 mm) with even a modest liquidity filter (min 50 cents per share and $10,000 of daily turnover). The holdings are replaced every 3 months. The red line is the 'small stock' portfolio and the blue line is the S&P 500 ETF (SPY).

Small Stocks Size Premium

The ups and downs are a lot more extreme with the total return being about the same as the S&P 500 if starting in 2001. If you look at the risk-adjusted returns, these small stocks are worse than the SPY. So where are these alleged buckets of alpha that researchers are finding? Below are three simple tips that you can use to build a historically robust portfolio of very small stocks which have out-performed the market.

Dividend Yield and Tiny Stocks

What comes to mind when considering stocks for a dividend stream? Are you thinking of massive blue-chip companies such as Johnson & Johnson (JNJ) and The Coca-Cola Company (KO)? Have you ever considered small-cap and micro-cap stocks as a source of dividends?

When you find very small stocks offering dividends, you often have a unique opportunity to generate above-average dividend yields combined with a larger share price return. There are a few reasons why dividends are powerful in small companies.

  • Small companies do not have as deep pockets as larger firms. Being cash-flow positive is key and is linked to out-performance.
  • Companies that pay dividends usually have confidence in their ability to do so based on cash flows. Typically, they are projected to be free-cash-flow positive over the long term.
  • Smaller companies also have higher upside potential. It is easier to grow revenue from $1 million to $100 million than from $1 billion to $100 billion.

Consider Taitron (TAIT) as one such example. It is a national supplier and distributor of electronic components. In 2018, its market cap was in the $8 to $12 million range. The trailing dividend yield in 2018 ranged from 4.5–7.5%.

Taitron Dividend Yield and Price 2018

In the past couple of months, the price has started to move. If you held Taitron since January 2019, you would have doubled your investment while still retaining a current trailing dividend yield of more than 3%. This is not the rule but it does nicely illustrate the point.

For our first filter, we will update our screen of smaller stocks to include only those which have a dividend yield of at least 3%.

Dividend Yield in Small Stocks

This one simple filter almost doubles the annual return.

Earnings Per Share and Growth

Overall, I prefer to focus on cash flows rather than earnings in smaller companies. A smaller company will live or die by the cash coming in and the cash going out. But earnings have their place. Although I view earnings as being less transparent (cash never lies while accrual-based accounting can mislead), it can give a very broad view of the landscape.

There are two ways which I use earnings when looking at smaller stocks.

  • Look for firms with positive earnings
  • Look for stocks where quarterly growth, year over year, is greater than -10%

Overall, a sustainable firm needs to be cash-flow positive with positive earnings. The lumpy returns of cash flows can make this challenging for small companies, so in this instance I will use earnings for simplicity sake. In addition to positive earnings, I also do not want to see earnings dive-bombing, so I apply a very loose quarterly growth filter.

Below is the return of small stocks with just those two filters applied (but not the dividend yield filter)

Positive Earnings and Earnings Growth

Low Volatility

Another useful tool when analyzing smaller stocks is to focus on those which trade with lower volatility. Why should this work?

In the 2018 paper, The Size Effect Continues to be Relevant When Estimating the Cost of Capital, the author adjusts the market-cap by Beta. Small and volatile is much worse than small with low volatility. There are many theories why this may be so, but one idea is that a company might be small because it is in financial distress or troubled. This troubled, high-risk company, would be more likely to exhibit a higher Beta. On the other hand, a stock with a small market cap that is not in distress or trouble is more likely to trade with lower volatility. Adjusting the market-cap by volatility could have you focusing on higher quality stocks that capture the size premium.

The screen below keeps the bottom 25% of stocks which have the lowest volatility in our investable universe.

Low Volatility Small and Microcaps

Combining All 3 Factors

This will summarize the complete portfolio set-up. First, we have our investable universe:

  • Any stock listed on a US exchange including OTC
  • Market-cap below $500 million
  • Minimum 50 cents per share and $10K daily turnover
  • Re-examine portfolio every 3 months

Next, we have our rules-based requirements:

  • Dividend yield greater than 3%
  • Earnings per share above 0
  • Quarterly earnings growth greater than -10% when compared to same quarter last year
  • Buy one-fourth of all remaining stocks which have the lowest volatility

Multi-factor microcap and smallcap portfolio

Below is a current list of smaller stocks that meet these criteria:

Ticker

Company

MktCap

Yield

EPS%Chg Qtr

(FDUS)

Fidus Investment Corp.

378.2

10.35

-3.92

(TPVG)

TriplePoint Venture Growth BDC Corp.

348.9

10.23

72.73

(AJX)

Great Ajax Corp.

266.82

9.07

3.03

(ACRE)

Ares Commercial Real Estate Corp.

439.68

8.63

59.09

(CORR)

CorEnergy Infrastructure Trust Inc.

454

7.9

183.78

(GAIN)

Gladstone Investment Corp.

406.01

7.57

-5.66

(ATAX)

America First Multifamily Investors LP

411.49

7.37

-4.35

(XAN)

Exantas Capital Corp.

344.74

7.35

182.14

(JCAP)

Jernigan Capital Inc.

429.03

6.67

357.89

(WSBF)

Waterstone Financial Inc.

463.75

5.92

-4

(OTC:NASB)

NASB Financial Inc.

302.79

4.88

20.88

(OTTW)

Ottawa Bancorp Inc.

43.28

4.39

228.57

(BCBP)

BCB Bancorp Inc.

217.77

4.22

10.34

(OTC:SWSSF)

Swiss Water Decaffeinated Coffee Inc.

40.71

4.17

172.1

(TBNK)

Territorial Bancorp Inc.

262.71

4.11

117.39

(OTCQB:PFOH)

Perpetual Federal Savings Bank

74.13

4.1

4.76

(LCNB)

LCNB Corp.

224.34

4.04

29.63

(CZNC)

Citizens & Northern Corp.

342.91

3.9

13.89

(OTCPK:QNBC)

Qnb Corp.

130.65

3.52

14.12

(OTCQX:ENBP)

ENB Financial Corp.

101.28

3.49

-8.08

(OTCQX:FMBM)

F & M Bank Corp.

98.99

3.25

67.35

(OTCQX:EFSI)

Eagle Financial Services Inc.

106.91

3.24

1.37

(OTCPK:KISB)

Kish Bancorp, Inc.

81.86

3.21

16.67

(OTCPK:IOFB)

Iowa First Bancshares Corp.

40.85

3.21

10.77

(LSBK)

Lake Shore Bancorp Inc.

91.94

3.14

88.89

(OTCQX:VABK)

Virginia National Bankshares Corp.

98.72

3.09

44.38

(MFNC)

MacKinac Financial Corp.

167.66

3.07

3,200.00

(OTCPK:AMNF)

Armanino Foods of Distinction Inc.

106.46

3.01

0

What Are The Risks?

There are risks when trading smaller stocks. I feel they are largely over-blown but you should be aware of them so you are not caught off-guard.

Liquidity risk. There is this fear that an investor will need to dump all his stocks in a window for a few hours and there will not be enough liquidity to sell into. If you are a long-term investor, this shouldn't be a concern of yours. A long-term investor generally feels that he cannot time the market and holds during bull and bear markets. If you need to sell, you should take your time and not dump shares. Now if you are concerned about the market for some reason and selling quickly is not an option, you can always short-sell an ETF to create a perfect hedge. Then sell shares at a responsible pace and remove the hedge accordingly.

Volatility risk. Smaller stocks can be volatile. But I mitigate that risk by choosing stocks which are profitable, can pay dividends and have low volatility. Risk addressed as can be seen in the equity curve. These stocks have far less volatility than their larger-cap counterparts.

Bankruptcy risk. Concerned that the small company you are buying might not be able to weather an economic storm? This is why I encourage a portfolio of stocks, at least 20 of them. You diversify the number of holdings to lower this type of risk. Having positive earnings also helps. Small companies with negative earnings or cash flows with strong negative growth can be dangerous.

Slippage risk. Here is where you need to be patient and smart. My rule of thumb is to invest no more than 5-10% maximum of the daily turnover. So if the stock trades $50K per day, only buy $5K per day at the most. Buy over many days to accumulate a large position. And don't trade too often. If you frequently trade illiquid stocks, you will lose your edge due to slippage. It is why the big boys avoid these since they cannot deploy large amounts of capital and retain alpha after slippage. Take your time and hold positions for at least 3 months when starting out.

Placing orders. There are some great order types by Interactive Brokers such as VWAP and Percent Volume. You can even make them non-aggressive which will give you a better entry point. I love using these algos to easily buy shares in illiquid stocks with ease. If you don't have these options, you can place a limit order. Never, under any circumstance, place a market order on these illiquid names.

Why do I feel that these risks are overblown? Because the out-performance more than compensates for these perceived risks. To me, real risk relates to me investing for 40 years only to find out that I made about 1/2 of my projected goal. If you can design a robust portfolio that generates true alpha but where individual companies might have slightly higher volatility risk or where you have to be a bit more patient when trading... that's a very easy decision for me to make. To me, bigger companies give a false sense of security that you trade for lower returns. But that's just me.

Summary

I should note that quantitatively analyzing the data for anomalies or factors is not the only way, nor even the best way, to produce high alpha. Some people are exceptional stock pickers and are able to find the next Apple (AAPL) or Amazon (AMZN) in its infancy stage. I have found one high potential stock with Surge Holdings that you can read about here. But finding individual companies to invest in is difficult and often relies heavily on guesswork and gut feelings. It is also incredibly time-consuming – who has time to properly analyze 8,000 companies every day?

Another powerful approach is to take advantage of factors which are historically linked to out-performance and build a portfolio of stocks with exposure to them. My personal experience is that small and illiquid stocks have the highest alpha in the market if you know how to extract it. And because of the lower liquidity the bigger firms largely ignore it, meaning more opportunity for the little guy. One idea for an alpha-generating portfolio is to buy smaller stocks with higher dividend yields, low volatility, positive earnings and earnings growth which is not overly negative.

But there are literally hundreds of different ways to generate alpha in smaller stocks. Care to share your ideas?

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.