Market

Small But Mighty: Small-Caps Outperform

It’s been more than a year since a major portion of the U.S. went into lockdown due to the coronavirus pandemic. After several federal coronavirus aid packages, widespread distribution of vaccines and states reopening, the economy continues to recover. Vaccines have helped many to return to a more normal life. The number of new cases continues to decline. None of this, however, means we’re totally in the clear.

Most people—both in the U.S. and internationally—have yet to be vaccinated. New variants of the coronavirus are spreading. Economically, many people remain either unemployed or underemployed. We still don’t know what the new normal will be.

However, overall, there is a feeling of optimism among investors driven by improving economic expectations, especially among smaller firms. Small-cap companies tend to be more sensitive to economic conditions.

Small-cap growth stocks are up 16.5% during the first half of the year, while small-cap value stocks are up 30.6%. The total return (including dividends) for the S&P SmallCap 600 index is 23.6% for the first half of the year and surpassed that of the mid- and large-cap index over the same period. The S&P MidCap 400 index is up 17.6% this year through June 30, while the total return for the S&P 500 index is up 15.3%.

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 stock-picking approach is up 164.3% year to date through June 30, 2021. This screening model has an average annual gain since inception (1998) of 20.1%, versus a 9.0% gain for the S&P SmallCap 600 index in the same period.

Investing in Small-Cap Companies

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. However, adjusting for inflation is important for more than 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 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 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. This methodology looks for those companies with the strongest price performance, but not necessarily a positive price change.

Top 10 Stocks Passing the O’Shaughnessy Small-Cap Growth and Value Screen (Ranked by 52-Week Relative Strength)

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

If you want an edge throughout this market volatility, become an AAII member.

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