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 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.
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