Small-Cap Quality

Model description

What This Strategy Aims to Do

This model aims to serve aggressive investors interested in high-quality small-cap growth and value stocks with the potential for outsize returns.

Why It’s Worth Considering

Research, both academic and investor-driven, has shown that small caps and microcaps are more sensitive to fundamental factors and indicators (quality, value, growth, sentiment) than large caps. They’re also less subject to the whims of the market as a whole, and tend to benefit more from deep financial analysis.

How We Do It

We start with a universe consisting of stocks with market caps between $200 million and $10 billion, and exclude stocks that are priced at less than $1, stocks with very low liquidity, and stocks with high bid-ask spreads. We also exclude REITs (real estate investment trusts), BDCs (business development corporations), and MLPs (master limited partnerships), because those kinds of companies require very different measures of quality in order to properly evaluate them. Lastly, we exclude stocks from corrupt countries and over-the-counter stocks, unless they are level II or level III ADRs (American depository receipts; these are US shares of stocks that trade on foreign exchanges). That leaves us with between 2,000 and 2,500 stocks.

We then work with a multi-factor ranking system to narrow these down to the top 30.

Most of the factors deal with the company’s quality. How stable is its income and operating margin? How high is its gross margin and its projected profit margin? How high is its debt load compared to its gross profit and its EBITDA? How low are its accruals? How rich is its free cash flow?

We look at the company’s value from a lot of different angles. Most important is the price-to-sales ratio, but we also look at forward earnings yield, gross profit to enterprise value, and a number of other measures in order to get a good overall picture.

In terms of growth, we’re looking at companies with high quarterly earnings and operating income growth, and moderate but steady and accelerating sales growth. We also look at factors that are predictive of future growth. For example, a company with relatively low return on assets/sales is more likely to experience strong earnings growth in the future than a company whose income is already high.

We’re particular about investing in certain industries and avoiding others. We look at what industry groups are most responsive to the factors we consider, and emphasize those; we also take into account how undervalued the industry is in free cash flow terms, and whether there’s some industry momentum we should consider.

Lastly, we also consider some sentiment indicators such as short interest, estimate revisions, earnings surprises, and share turnover.

There’s one thing that this model does not take into account at all, and that’s a stock’s price history. The price of a stock you buy should be low, but not necessarily compared to what it was before. We believe that a stock’s price history should have little influence upon buying and selling decisions.

Is It Suitable For You?

This model is only suitable for investors who are comfortable with trading weekly and investing in small companies that are flying under most investors’ radar. And due to heavy trading activity, it is suitable only for those who enjoy low-cost trading arrangements.

You can start following the model here.