Small but powerful: small caps outperform

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It has been over a year since much of the United States was stranded due to the coronavirus pandemic. After several federal coronavirus aid programs, widespread vaccine distribution and reopening of states, the economy continues to recover. Vaccines have helped many people return to more normal lives. The number of new cases continues to decline. None of this, however, means that we are totally in the clear.

Most people, both in the United States and abroad, have not yet been 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.

Overall, however, there is a sense of optimism among investors, driven by improving economic expectations, especially among small businesses. Small cap companies tend to be more sensitive to economic conditions.

Small-cap growth stocks are up 16.5% in the first half of the year, while small-cap value stocks are up 30.6%. The total return (including dividends) of the S&P SmallCap 600 Index was 23.6% for the first half of the year and exceeded 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 of the S&P 500 Index is up 15.3%.

For the patient investor able to withstand the short-term volatility and higher risk of small-cap stocks, there is the potential for strong long-term returns. AAII O’Shaughnessy Selection of small cap growth and value stocks is up 164.3% since the beginning of the year until June 30, 2021. This filtering model has an average annual gain since its inception (1998) of 20.1%, against a gain of 9.0 % for the S&P SmallCap 600 Index over the same period.

Invest in small cap companies

AAII follows several screens from James O’Shaughnessy, Founder and Chairman of O’Shaughnessy Asset Management LLC, an asset management firm based 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 Most Successful Investing 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 dynamics using both growth and value criteria. The screen looks for “cheap stocks on the mend”. Much research has been done on the success of investing in this category of market capitalization. AAII Model phantom stock portfolio is based on research that has shown that small and micro cap stocks tend to outperform the overall market over long periods of time.

O’Shaughnessy believes the reason for this outperformance is that few analysts are following these smaller stocks. Additionally, many institutional investors and mutual funds cannot trade these shares without changing the price, due to the relatively small number of shares outstanding. This leaves room for surprises, which can lead to a “pop” performance. O’Shaughnessy also says that small-cap stocks have a low correlation to the overall stock market, making them a potential hedge in a larger-cap equity portfolio.

Positive earnings growth and strong price strength relative to the market

The AAII version of the O’Shaughnessy small-cap growth and value stocks screen has very few criteria. First, all foreign stocks and OTC 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 annum. However, the adjustment for inflation is important for more than the calculation of portfolio returns. By adjusting market caps during backtesting and going forward, you are better able to maintain a database of desired cap stocks, regardless of the effect of inflation on asset size.

After filtering for larger cap stocks, the AAII screen searches for stocks with price / sales ratios less than 1.5. The price-to-sales ratio compares the current stock price to a company’s sales. O’Shaughnessy uses this as an indicator of “cheap”, as opposed to a price-earnings ratio. He explains that all viable businesses have sales and that sales are harder to manipulate than profits. In What works on Wall StreetO’Shaughnessy found that stocks with low price-to-sell ratios produced higher returns.

Growth in earnings per share (income less cost of sales, operating expenses, and taxes, over a period of time) is a common way to measure a company’s growth potential. Earnings per share play a vital role in the price of a stock, primarily due to market expectations. Low or negative profits are often a sign of start-ups; However, these start-ups are trying to increase their profits quickly and can be profitable investments. The O’Shaughnessy Small-Cap Growth and Value screen finds stocks whose earnings per share growth for the past 12 months is greater than zero.

Multiple price appreciation factors also help find companies with rising profits and rising stock prices. This screen looks for stocks with above-average relative strength over 13 and 26 weeks against the S&P 500.

O’Shaughnessy believes investors should hold 25 stocks in this small-cap portfolio in order to diversify the risk associated with holding such volatile stocks. Thus, the field is further reduced to the 25 actions with the highest relative strength over 52 weeks. There are currently 25 companies passing the O’Shaughnessy Small-Cap Growth and Value screen.

For an equity investment strategy to be useful, it must be investable. This means that a quantitative approach must generate a sufficiently large universe of passenger companies on which to perform additional due diligence to identify investment candidates. Since the O’Shaughnessy Small-Cap Growth and Value screen searches for the 25 highest-priced companies in the past year after applying the market capitalization and value filters, there are usually companies passing. Keep in mind, however, that there may be times when the companies with the “best” price force may still be down in the past 52 weeks. This methodology looks for companies with the best performing prices, but not necessarily a positive price change.

Top 10 stocks passing the O’Shaughnessy small-cap growth and value screen (ranked by relative strength over 52 weeks)

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Stocks that meet the criteria for the approach do not represent a “recommended” or “buy” list. It is important to exercise due diligence.

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


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