John Reese is CEO of Validea.com and Validea Capital, and portfolio manager for the Omega Consensus funds. Globe Investor has a distribution agreement with Validea.ca, a premium Canadian stock screen service. Try it.
In the stock market, thinking small can lead to big rewards.
That's what 85 years of history has shown. From 1927 through 2012, one dollar invested in the total U.S. stock market would have grown to just shy of $3,000, according to Index Fund Advisors. The same dollar invested in a basket of small U.S. stocks? It would have grown to nearly five times as much: $14,580.
In explaining the reason why small stocks have outperformed their larger peers, Eugene Fama of the University of Chicago has noted that smaller stocks tend to be riskier and have a higher cost of capital, which means investors demand higher returns for investing in them.
In today's era of information overload, small stocks may have even more of an advantage. That's because larger stocks are followed by hordes of analysts, making it harder to find hidden gems. Smaller stocks, meanwhile, may be followed by few, if any, analysts.
That doesn't mean you should just dive headlong into any old small stock. In fact, because small stocks and smaller companies can be more volatile, you should use a rigorous approach when analyzing them.
That's what my Motley Fool-inspired Guru Strategy does. Based on a method laid out by brothers Tom and David Gardner, co-creators of the Motley Fool website, this small-cap strategy looks at 17 variables, putting smaller stocks through the wringer to make sure they are on solid financial footing – and trading at a good price.
Since 2003, I have tracked a series of model portfolios on my research site, Validea, and the Motley Fool-based portfolio is one of the best – returning 15.1 per cent annually (compared with 5.3 per cent for the S&P 500). And the excellent performance has continued. In the Canadian market, the 10-stock Fool strategy on Validea Canada has jumped 37.4 per cent, far outpacing the S&P/TSX composite's 7.6-per-cent gain since its August, 2010, inception.
The Fool-based model's criteria include:
- Growth: Both sales and earnings should have grown by at least 25 per cent in the most recent quarter (versus the year-ago quarter);
- Momentum: The stock should have a 12-month relative strength of at least 90;
- Profit margins: They should be high – at least 7 per cent in the most recent year – and consistent or rising over the past three years.
- Balance sheet: Free cash flow should be positive, and the long-term debt-to-equity ratio should be no higher than 5 per cent.
- Valuation: The Fool-based model is a growth approach, but it also includes a key valuation metric: the “Fool Ratio,” which is essentially the P/E-to-growth (PEG) ratio that Peter Lynch made famous. (It divides a stock’s trailing 12-month P/E ratio by its long-term growth rate.) This ideally should be no greater than 0.5, though it can be slightly higher if the firm’s other fundamentals are excellent.
- Size/price: Annual sales should be less than $500-million, and daily dollar volume no greater than $25-million. These criteria help target under-the-radar stocks that are more likely to be overlooked.
Meeting all of these criteria is exceptionally difficult, and it's very rare that a stock will get a perfect 100 per cent score. But even when a stock scores in the 70- to 80-per-cent range, that can mean it's a good opportunity.
Here's a look at some of the Fool-based model's favourite Canadian stocks right now. Keep in mind that some of these are very small, lightly traded stocks, so they may be subject to a good deal of short-term volatility.
- Constellation Software: This Toronto-based tech firm provides software and services, to groups in both the public and private sector, often targeting niche markets. Constellation is actually a smaller sized mid-cap ($3.7-billion) that increased sales more than 40 per cent in the most recent quarter. Its profit margins are above 10 per cent, it has a relative strength of 92, it has no long-term debt, and its shares trade at a PEG of 0.54. All of that helps it earn a 77-per-cent score from the Fool-based model.
- Genworth MI Canada: Ontario-based Genworth is a private residential mortgage insurer. Like Constellation, it’s technically a smaller sized mid-cap ($2.8-billion), but it gets a solid 81-per-cent score from my Fool-based model. The strategy likes its stellar 62-per-cent profit margins and 0.47 PEG ratio. Genworth’s relative strength doesn’t quite pass the Fool test, but at 85 per cent it’s close.
- Paladin Labs: This Montreal-based specialty pharmaceutical company took in $280-million in sales in the past year. It grew sales at a 79.5-per-cent rate last quarter, has 28.5 per cent profit margins and a debt-to-equity ratio of just 1.3 per cent, all of which help earn it a solid 74-per-cent score from the Fool-based model.
- Celestica: This Toronto-based firm offers a range of supply chain solutions for the computing, defence, health care and green tech markets. It operates in Asia, Europe, and the Americas. Celestica gets a 70-per-cent score from my Fool-based model for a few reasons: It grew earnings at a 36-per-cent pace in the most recent quarter, has no long-term debt, and has a strong relative strength of 92. Shares do look a bit pricey, however, trading at a PEG ratio of about 1.2.
- AutoCanada: This Edmonton-based company is one of Canada’s largest multilocation automobile dealership groups, operating 30 franchised dealerships in six provinces. The $750-million-market-cap firm gets a 74 per cent score from my Fool-based model.