How To Track Down Small-cap Outperformance In Cheap And Fast-moving Shares

13th Sep '17 by Ben Hobson

9 comments 12913 reads

One of the challenges of investing in the stock market’s smallest companies is that many lack good quality research coverage. For some investors, this sort of information vacuum is enough to send them running for the hills. But for those prepared to do their homework, it can offer a chance to profit where others fear to tread.

To illustrate the potential power of smaller companies, it’s worth looking at the performance of a simple micro-cap strategy tracked by Stockopedia in recent years. Since 2012, the James O’Shaughnessy-inspired Tiny Titans screen has delivered consistently strong returns, including a 74 percent gain in the UK over the past two years. It’s achieving those results with shares that are valued at less than £150 million (and often much less) - so they’re right at the smallest end of the market. We’ll explore this strategy further in a moment.

The case for small-caps

There are some strong arguments in favour of having a small-cap allocation in a portfolio. Research into long-run investment returns shows that small-caps generally outperform large and mid-caps over time.

This is regularly shown in analysis by Credit Suisse and academics from London Business School. Their charts below show that between 1926 and 2015 in the US, and 1955 and 2015 in the UK, the smallest stocks beat the rest of the market overall.

Source: Credit Suisse

Findings like these tally with the views of academics that smaller stocks outperform over time - even though, individually, they tend to be more volatile.

Luminaries like Eugene Fama and Kenneth French first argued this in the early 1990s. And as recently as 2015, researchers at the the hedge fund AQR showed that you could profit from the small-cap size premium by focusing on high quality.

But O’Shaughnessy’s original Tiny Titans strategy takes a different approach to finding the best prospects among small, under-researched stocks. In his 2006 book, Predicting the Markets of Tomorrow, he set out the case for investing in small-caps with a strong blend of attractive value and strong price momentum.

O’Shaughnessy’s strategy focused on companies that were cheap based on their price-to-sales ratio (which has to be less than 1.0x). He argued the P/S was a harder ratio for management to manipulate than other…

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iwright7

13th Sep '17

Ben,

Interesting article and I do think it is useful to have a small (<15%?) of a portfolio as microcaps in the hope/expectation that 1 or 2 will multi-bag, without creating substantial portfolio downside risk.

There is a brilliant US podcast with son Patrick O'Shaughnessy and the specialist microcap investor Ian Cassel who specialises in buying into <$50M Market Cap companies here...

http://investorfieldguide.com/...

Logic

Shares of all cap sizes may be worth holding, but I often see small or microcaps hailed as some form of panacea, and would just like to add a word of caution. A long time ago, I read one of Dreman's books on investing. In it, he strongly criticised the suggestion that "small cap stocks don't always do well, but when they do, they do great". Unfortunately I cannot recall what page, what book, or even all of his arguments. But they did include things such as that thin trading eating into your profits, that some historical prices are misleading, etc. Perhaps someone else can recall the rest, he's not that unknown of an author after all.

Peter Craven

Ben,

Your article identifies the truth that lack of quality research on small cap companies sends investors running for the hills. This is certainly true in my case.

Its is never going to be appropriate to select a small cap company using simple technical metrics such as Price to sales ratio <=1 or a 1 year relative price strength metric. Its telling though that micro and small caps statistically outperform large caps by 1.9% and 5.9% respectively. Although its not clear if the research refers to the price gain or the compound gain (dividend and price gain without dividends re-invested).

The issue that needs to be addressed is the quality and completeness of information available to the investor through company web sites, financial reports and presentations. I am aware that fund managers speak directly to company representatives in order to gain a deeper understanding what a company does and what its prospects are.
Not sure if companies would welcome the attentions of private investors like me with investment related queries.

ricky65

Interestingly, I used to hold Creightons (LON:CRL), Molins (LON:MLIN), Hargreaves Services (LON:HSP), and made a good profit on all of them, especially the first two. I'm still holding Northern Bear (LON:NTBR). They all met my Minervini inspired criteria. From my experience the successful small caps I've invested in are profitable, have a decent balance sheet and met Minervini's Trend Template. I avoid almost all blue sky small caps that have never made a profit as they are too prone to failure; I've only ever had short term success with them.

14th Sep '17

One small refinement to the screen that I suggest to to add F-Score >5. This combines Piotroski concept of "improving" companies with O’Shaughnessy's value and momentum aspects. This addition cuts the number of O’Shaughnessy value type companies down from 39 to 22.

Nevertheless the Stocko's existing Tiny Titans screen has done incredibly well, as it is. Ian

Howard Marx

I fully agree with the tone of the comments above that Quality has to be a screening factor when focussing on small/micro caps given the abundance of 'junk' that lurks in this area.

A great paper on this was published by AQR:

https://www.aqr.com/library/wo...

Richard Goodwin

15th Sep '17

In my experience it depends upon the company. Some are absolutely delighted to gain PI attention!

16th Sep '17

I brought O'Shaughnessy's Predicting Markets of Tomorrow via Amazon Used for the princely sum of £5.02 delivered direct from the US - What a easy read and highly recommended.

O'Shaughnessy back tested Tiny Titans from 1951-2004 and produced an average return of 18,.9%. He does though point out periods of gut renching draw downs, so high volatility in the short term is par for the course. This seems to be born out in the US above table where the TT method has preformed abysmally over the last 5 years. This may reflect the poor performance of all US value methods in recent years.

O'Shaughnessy quotes the wisdom of Winston Churchill, “The farther back you can look, the farther forward you are likely to see.” Ian

MD SAFDAR IMAM FATMI

5th Oct '17

excellent

How to track down small-cap outperformance in cheap and fast-moving shares

The case for small-caps

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Ben Hobson

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