How to make use of this historic opportunity in small cap stocks
O’Shaughnessy Asset Management just published an interesting research paper
called
A Historic Opportunity in Small Cap Stocks
.
Here is an extract from the paper (I added the bold comments):
A HISTORIC OPPORTUNITY IN SMALL CAP STOCKS
Every so often there are opportunities that may only appear 2-3 times
in an investor’s career, usually around a bear market or recession. In
light of the recent bear market, evidence suggests that a historic
opportunity may be forming in small cap stocks, among the lowest
returning assets in March (Russell 2000 Index, -21.73%) and Q1 (Russell
2000 Index, -30.61%).
Yet,
small cap stocks are one of the better returning assets after bear
markets
. As the data below shows, small stocks are generally the lowest
performers as markets fall, but then significantly outperform when markets recover
.
…
Small Cap Value & Large Cap Growth Spreads Near All Time Highs
Using history as a guide, the current environment in small cap stocks
is almost unprecedented. When comparing the earnings yield of the
cheapest small stocks (cheapest decile by price-to-earnings) to the
most expensive decile of large cap stocks in the US we see a spread of
more than 21%. Following extreme periods like this historically
, small value outperformed large growth by 16.8% annualized over
the following 10 years.
Earnings Yield Spread on Small Cap Value & 10-Year Treasury
Near All Time Highs
A similar dynamic exists in the earnings yield on small cap stocks
(cheapest decile) and the 10-year U.S. Treasury yield. This spread is
generally between 3-6%, but is greater than 20% today. Following
similar spreads in the past,
small value stocks returned an average of 27.9% in the subsequent
10-year period.
…
INCORPORATING QUALITY IN SMALL CAP VALUE
While small cap value has a long record of generating meaningful
outperformance, we must emphasize that
investors should not simply buy the cheapest decile of small stocks
. Due to their size, small cap companies are generally more susceptible
to economic shocks like the one we currently face. By merely buying the
cheapest group of small cap stocks, there is no safeguard protecting
investors from unstable companies ill-prepared for an economic
downturn.
For this reason, it is
crucial to incorporate quality factors in the investment process
for avoiding these unprepared and ill-equipped companies. At OSAM, we
screen out companies from our investable universe that score poorly
on Financial Strength (highly levered companies
reliant on external funding), Earnings Quality
(companies with non-cash earnings and aggressive accounting), and Earnings Growth (declining free cash flow and
profitability).
This is how you find quality cheap small caps
If this sounds interesting here is an article that shows you exactly how to
find quality undervalued small cap companies:
This simple Microcap investment strategy beats the professionals – Data
driven.
The screen you should use is shown further down on the article so just
scroll down a bit.
Remember you can apply this strategy to any country not just in the USA.
Look for the smallest 2000 companies
The Russell 2000 Index, mentioned above, is a small-cap stock market index
of the smallest 2,000 US stocks.
As of 31 December 2019, the weighted average market value of a company in
the index was around $2.48 billion; the median market value was $821
million. The market value of the largest company in the index was $8.27
billion
This gives you a good idea of where to set your market value limits in the
screener. Perhaps deduct 30% from the above values to compensate for the
fall in the markets so far this year.
This screen can also help you
For a few other ideas on how you can make the most from the current market
crash take a look at this article:
How to find great investments when the market crashes
PS
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