5 Easy Rules To Find Good Small-cap Stocks

19th Dec '23 by Roland Head

6 comments 5104 reads

This week I want to return to my back-to-basics theme, with a look at a simple set of rules that might be used to help find good small-cap stocks. The smaller end of the stock market can be a fertile hunting ground for growth stocks and potential multibaggers, as Ed discussed in his recent webinar and masterclasses.

(In the previous instalment of this mini-series, I created a simple screen to help find good dividend stocks – you can find that here.)

It’s easy to build more complicated screens with lots of rules – and that’s something I quite like to do. But I’ve often found that after a while, there can sometimes be a certain amount of overlap and redundancy between rules.

Screens can also become too exclusive, as good companies don’t necessarily fit an exact financial profile.

On a related note, it’s worth remembering that screen results are always best used as a tool to narrow down the market and provide ideas for further research. With this in mind, I think there’s some value in trying to distil what we’re looking for to its simplest form.

Given the historical success rate of the StockRanks, I also think it makes sense to leverage this powerful tool when building a screen. That’s what I’ve done here.

Here’s a snapshot of the rules I’ve created and a look at some of the shares highlighted by the screen.

My easy small-cap screen

The idea was to create enough rules to capture some essential qualities, without including anything unnecessary.

In this case, I asked myself what the absolute minimum criteria would be that I’d associate with a good small-cap stock. I’m not looking for outliers here, such as turnarounds or special situations. What I want are profitable, growing businesses, without too many complications or obvious risks.

Here’s what I decided:

Market cap: the definition of a small cap tends to vary, depending on who you ask. In US markets, small caps also tend to be larger than in the UK.

I’ve chosen a range of £25m - £750m because I think this covers a range that has historically been rich with opportunity, without being too speculative. Companies in this size range are small enough to multibag, but should also be reasonably well established.

StockRank: in Ed’s…

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Wheeler1

19th Dec '23

Interesting list - as Roland says some familiar names. I've added a rolling 1 yr P/E <16 to reinforce the value element and ended up with a list of 38.

JASVFS

As a lower league investor on Stockopedia, noting many smarter ones on these forums, I'm delighted to have have 7 on your interesting list Roland plus several more I intend to add. Thank you.

Zipmanpeter

The ethos of this site is DYOR - a few articles explaining what this means for different writers might be interesting, especially for firms/sectors ordinary investors wont know ie not consumer facing stocks but obscure industrials for instance

Peez Peez

20th Dec '23

Strong sales growth is the leading indicator of future profitability. This is because strong sales growth often lead to operating margins expansion as companies gain leverage against their fixed costs, and in turn boost operating income growth and multiple rating.

There are five different ways companies can boost their sales growth: 1) selling more in existing markets due to more efficient markets, 2)increase prices, 3) new products introduction , 4) new market expansion and 5) acquisitions . These can act as catalysts for stock price appreciations.

In general, stocks should trade in line or a modest premium to their growth rates. For example, a stock expected to grow at 20% should trade at 20x forward P/E multiple to as high as 40x forward P/E multiple. The key question is whether its total addressable market, quality of its products or services and management team can support that level of growth going forward.

Stocks trading at a discount to their growth rates are excellent long-term investments. This is because the low multiples give them greater scope for multiple re-rating if their profits can grow at a respected rate. Meanwhile, this should limit the risk of multiple compression if their profits do go into reversal.

Stocks with minimal profits will have high P/E and this make them look expensive. The key questions to ask are: 1) Are their current profits being material depressed by major investments? 2) Is there a reason to believe that its long-term operating margin can be substantially higher than current level? and 3) Can its strong sales growth be sustained over a long-time? If the answer to all these questions are positive, they can still be good long-term investments with higher valuation risk if their profits don't grow as fast as the market expected.

In short, look for stocks that are generating strong sales driven by successful execution of growth initiatives and where there is potential for operating margin expansions. Meanwhile, buying them when they are trading at a discount to their growth rates reduces valuation risk and provides greater scope for multiple rating. This is a triple positive whammy effect (Sales growth x operating margins expansion x multiple re-ratings).

anthonyburns1979

27th Dec '23

Thanks Roland

Paul Scott

28th Dec '23

Really interesting article, thanks Roland! I recognise lots of your screen's results from the SCVR, as you say. The screening tool is so useful, but it definitely helps give me ideas, to see the method and parameters used by you, and others. So setting out an example screen like you've done above is really helpful.

5 easy rules to find good small-cap stocks

My easy small-cap screen

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Roland Head

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