- Investing in small-cap companies using the O’Shaughnessy growth & value screen.
- Positive earnings growth & strong price strength relative to the market.
- Top 10 stocks passing the O’Shaughnessy growth & value screen.
Today, I cover the O’Shaughnessy Small-Cap Growth and Value stock-picking strategy and give you a list of stocks that currently pass our screen based on the approach. The O’Shaughnessy Small-Cap Growth and Value strategy focuses on small-cap stocks with upward price momentum using both growth and value criteria. Small-cap stocks normally do well during economic recoveries.
There is a feeling of optimism among investors driven by positive vaccine trials, coronavirus vaccine administration ramping up and improving economic expectations, especially among smaller firms. Small-cap companies tend to be more sensitive to economic conditions, and investors rotated into economically sensitive stocks as positive results of coronavirus vaccine trials surfaced during November.
Shares of small U.S. companies have soared past larger firms to start 2021, after last quarter’s rally continued into January. The gain for the small-cap Russell 2000 index for the year surpassed that of the mid- and large-cap S&P 500 index for the month of January. The small-cap index is up 5% this year through January 29, compared with a loss of 1.1% for the mid- and large-cap index.
There are a few positive trends contributing to small-cap stocks’ strong growth. According to Morningstar, few companies announced earnings disappointments; investors who had been selling value stocks abated a bit; fundamental news has been encouraging, especially from companies supplying auto, food, housing and capital goods companies, where there had been little capital investment and inventories were tight; and the risk-reward proposition was attractive.
For the patient investor with the ability to withstand the higher short-term volatility and risk of small-cap stocks, there is the potential for strong long-term returns. AAII’s O’Shaughnessy Small-Cap Growth and Value approach is up 77.9% year to date through January 29, 2021. The O’Shaughnessy Small-Cap Growth and Value screening model has an average annual gain since inception (1998) of 18.4%, versus 8.5% for the S&P SmallCap 600 index in the same period.
Investing in Small-Cap Companies Using the O’Shaughnessy Growth & Value Screen
AAII tracks several screens from James O’Shaughnessy, the founder and chairman of O’Shaughnessy Asset Management LLC, an asset management firm headquartered in Stamford, Connecticut. The O’Shaughnessy screens that AAII has developed are based on the strategies outlined in his books “What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time,” (3rd Edition, 2005, McGraw-Hill) and “Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years,” (2006, Penguin Group).
O’Shaughnessy’s Small-Cap Growth and Value approach focuses on small-cap stocks with upward price momentum using both growth and value criteria. The screen seeks “cheap stocks on the mend.” Much research has been done regarding the success of investing in this market-cap category. AAII’s Model Shadow Stock Portfolio is based on a study that showed that small- and micro-cap stocks tend to outperform the overall market over long periods.
O’Shaughnessy believes the reason for this outperformance is that few analysts follow these small stocks. Also, many institutional investors and mutual funds cannot trade these stocks without moving the price, due to the relatively small number of outstanding shares. This leaves room for surprises, which can lead to a performance “pop.” O’Shaughnessy also says that small-cap stocks have a low correlation with the overall stock market, making them a potential hedge in a portfolio of larger-cap stocks.
Positive Earnings Growth & Strong Price Strength Relative to the Market
AAII’s version of O’Shaughnessy’s Small-Cap Growth and Value stock screen consists of very few criteria. First, all foreign stocks and over-the-counter stocks are eliminated. Next, a stock’s market capitalization must be between $200 million and $2 billion. O’Shaughnessy adjusted these criteria limits for inflation using the long-term average rate of 3% per year. Adjusting for inflation is not only important for calculating portfolio returns. By adjusting the market caps when backtesting and going forward, you are better able to maintain a database of desired cap-size stocks regardless of inflation’s effect on asset size.
After filtering out the larger-capitalization stocks, AAII’s O’Shaughnessy Small-Cap Growth and Value screen looks for stocks with price-to-sales ratios of less than 1.5. The price-to-sales ratio compares the current stock price to the sales of a company. O’Shaughnessy uses this as a proxy for “cheapness,” as opposed to a price-earnings ratio. He reasons that all viable companies have sales, and sales are harder to manipulate than earnings. In “What Works on Wall Street,” O’Shaughnessy found that stocks with low price-to-sales ratios produced higher returns.
Earnings per share growth (revenues minus cost of sales, operating expenses and taxes, over a given period of time) is a popular way to measure a company’s growth potential. Earnings per share play a critical role in a stock’s price, mainly due to market expectations. Low or negative earnings are often signs of young companies; however, these start-ups attempt to grow earnings quickly and can be profitable investments. The O’Shaughnessy Small-Cap Growth and Value screen finds stocks with earnings per share growth for the trailing 12 months that is greater than zero.
Multiple price appreciation factors also help find companies that are growing earnings and whose stock prices are rising. This screen looks for stocks with above-average 13- and 26-week relative strength as compared to the S&P 500.O’Shaughnessy thinks investors should hold 25 stocks in this small-cap portfolio to diversify the risk that goes along with holding such volatile stocks. So, the field is further narrowed to the 25 stocks with the highest 52-week relative strength. There are less than 25 companies passing the O’Shaughnessy Small-Cap Growth and Value screen at this time.
For a stock investment strategy to be useful, it must be investable. That means a quantitative approach needs to generate a large enough universe of passing companies on which to perform additional due diligence to identify investment candidates. Since the O’Shaughnessy Small-Cap Growth and Value screen looks for the 25 companies with the highest price strength over the last year after applying the market cap and value filters, there are typically companies passing. Keep in mind, however, that there may be periods when the companies with the “best” price strength may still be down over the last 52 weeks. The O’Shaughnessy Small-Cap Growth and Value methodology looks for those companies with the strongest price performance, but not necessarily a positive price change.
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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Analyst's Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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