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Four of the Safest Small-Cap Stocks


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.


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 apprecia-tion, 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 lev-els.

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 momen-tum 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 momen-tum strategies sport an amazingly negative (i.e., good) correlation with each other. Negative correlations within a portfolio reduce downside vol-atility 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 histori-cally 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 re-quired 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.

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No positions in stocks mentioned.
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