The delicate balance of risk and reward in the small-cap space can be achieved if you approach your stock selection with a good set of criteria, notes Jim Fink of Personal Finance.
Small-cap investing comes in two varieties—growth/momentum and value. Growth/momentum stocks sport premium valuations, such as high price-to-earnings (P/E) ratios and strong 12-month price appreciation, but also generate strong financial results to match.
These companies are doing well now, and the trend is your friend. A continued, gradual ascent is likely. No patience is required, but their high valuations risk sharp but temporary pullbacks along the way to higher levels.
In contrast, “value” stocks (e.g., low P/E ratios) typically have not done well lately, but are financially strong and primed to bounce back strongly when industry conditions improve. But investors can do even better than small-cap value alone. Academic research has found that a combined portfolio of value stocks and momentum stocks performed the best, beating the performance of value or momentum stocks alone by almost double.
The reason for the combo’s superiority is that the value and momentum strategies sport an amazingly negative (i.e., good) correlation with each other. Negative correlations within a portfolio reduce downside volatility and smooth out returns.
Six-Point Safety Rating
I’ve developed a six-point “safety rating” system for our subscribers that steers us away from stocks exhibiting risky characteristics that historically have led to problems down the road. For each of the six measures, a stock gets one point if it exceeds a threshold level. A score of six is the safest and a score of zero is the riskiest.
Below is a description of each safety criterion and the threshold required to get one of my safety points:
1. Piotroski F-Score of 6 or Above. Stanford University Accounting Professor Joseph Piotroski developed a nine-point checklist of financial performance over the past two years to determine the financial strength of small-cap value stocks. Four measure profitability, three measure cash liquidity, and two measure operational efficiency.
The strongest companies score 9 and the weakest a zero. To get a positive rating on my safety scale, the F-score must be at least 6.
2. Beneish M-Score of -2.00 or More Negative. Indiana University Accounting Professor Messod Beneish developed an eight-point checklist of year-over-year accounting changes that historically have provided evidence of earnings manipulation.
Scores more negative than -1.78 indicate a firm that exhibits relatively conservative accounting, whereas scores more positive than -1.78 indicate a potentially fraudulent company. I require the M-score to be at least -2.00 or more negative to earn a safety point.
3. Altman Z-Score of 3.5 or Above. NYU Finance Professor Edward Altman developed a five-part financial formula to measure the probability of bankruptcy within two years. The criteria include measures of profitability, liquid assets/short-term solvency, operational efficiency, and equity capital/long-term solvency. Minimum safety is 3.0, so I require 3.5 before a stock can claim a positive safety point.
4. Ratio of Short Interest to Float of Less than 10%. “Short interest ratio” is defined as the number of shares shorted divided by the number of shares available for trading (i.e., the public float). A 2004 MIT and Harvard study found that stocks with the highest short interest ratios (99th percentile) underperformed on average by 125 basis points per month (15% per year).
To qualify for the 99th percentile, the stock typically has a short interest ratio of 20% or higher. I only give a safety point if a stock’s short interest ratio is less than 10%.
5. 10% Insider Ownership or Recent Insider Buying. Academic studies conclude that insider buying is much more indicative of future stock returns than insider selling. Consequently, to earn a safety point from this measure, I must see at least 10% insider ownership or significant insider buying within the past six months.
6. Beta of Less than 1.0. Beta is a measure of an individual stock’s volatility relative to a stock index (e.g., S&P 500). By definition, a stock exhibiting a lower beta is less risky. Furthermore, academic studies have found that low-beta stocks outperform.
A beta equal to the market is 1.0. The average stock in the Russell 2000 small-cap stock index has a beta relative to the large-cap S&P 500 index of 1.3. Consequently, a stock earns a safety point if its beta is less than 1.0.
Four Hidden Gems
I’ve uncovered four hidden gems that should thrive in the current global economic and political climate, and generate outsized returns for investors for years to come. Here’s a closer look at each.
PriceSmart (PSMT) is the largest operator of membership warehouse clubs in Central America, South America, and the Caribbean. PriceSmart serves over 1 million cardholders at 30 warehouse clubs in 12 countries and the US Virgin Islands.
PriceSmart isn’t just a Costco (COST) wannabe imitator; it was actually spun off from Costco (then called Price Costco) in 1994. Former Price Costco Chairman of the Board Robert Price has been PriceSmart’s Chairman of the Board ever since the 1994 spinoff.
The market capitalization of PriceSmart’s stock is currently $2.2 billion, whereas Costco’s is $44.1 billion. I’m not saying that PriceSmart will grow 20 times in value to equal Costco’s market cap, but even a fraction of that catch-up growth will make current investors rich.
Gentex (GNTX) has a virtual monopoly on automatic-dimming car mirrors (87.9% market share). Right now, these high-tech mirrors are only installed in 23% of cars worldwide (45% to 50% in North America), but Michigan-based Gentex sees the global percentage increasing to 45% over the next decade, which would mean $3 billion in additional revenue.
Since the company’s entire market cap is currently only $2.6 billion, the prospects for stock-price appreciation are tremendous. The company is a true value stock, trading at only 16 times earnings when its historical five-year average multiple is closer to 26.
The stock will most likely return to a 26 P/E multiple. With current earnings per share (EPS) of $1.17, that would mean a stock price of $30— more than 60% higher than the current level.
Buckle (BKE) is headquartered in Nebraska and operates 440 apparel stores in 43 states, focusing on jeans (40% of sales) and tops (30% of sales) for those aged 15 to 30 years, including both women (55% of sales) and men (45% of sales).
Chairman of the Board Daniel Hirschfeld and CEO Dennis Nelson collectively own 40% of the company’s stock. Therefore, management’s financial incentives are aligned with the average shareholder.
The company pays an 80-cent regular annual dividend, and has added a special dividend of at least $2 in each of the five years since October 2008. The stock’s total dividend yield is near 7%, which is much higher than most apparel stocks.
Buckle is extremely profitable with the highest operating margin in the apparel industry, returns on invested capital of almost 40%, and annual EPS growth of almost 15% over the past ten years.
United Therapeutics (UTHR) focuses on the treatment of a relatively rare disease called pulmonary arterial hypertension (PAH). The 250,000 people worldwide who suffer from PAH have high blood pressure in the arteries of their lungs.
The global market for PAH treatment is roughly $4 billion in annual sales, and United Therapeutics currently has about a 15% overall market share. However, United Therapeutics is the market leader in treating severe PAH, with its Remodulin brand controlling 80% of the market.
Annual drug treatment costs for severe PAH can run upwards of $90,000 per year; United Therapeutics is a very profitable company despite serving a small patient base.
The company has generated 25% compounded annual revenue growth—all organic and not based on acquisitions—for ten consecutive years. It sells for only ten times earnings, has almost $10 per share in cash, and last year earned a solid $3.67 per share in earnings.