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Revisiting a Small-Cap Value Screen

(Guest Commentary By Bill Rempel – August 7, 2008)

Dear Subscribers and Readers,

For those who had wanted to learn more about individual stocks, the art of stock selection, and model-based trading/investing, it is again time to turn to one of our regular guest commentators, Bill Rempel.  Bill is a prolific writing on the stock market and individual stocks and is the author of a very active market blog at: http://billrempel.com (“The Rempel Report”). 

In this commentary, Bill is going to provide us an update on his small cap value screen, which he initially discussed in his May guest commentary.  Bill will then further extend his analysis to large cap stocks – ending with a discussion on momentum-based strategies.  Without further ado, following is a biography of Bill:

Bill Rempel (aka nodoodahs) is an active poster on the MarketThoughts forum as well as a few others around the web. Bill is a regular, monthly guest commentator on our website (see “A Second Look at the Yield Curves” for his last guest commentary). Bill graduated from Caddo Magnet High School (a high school for nerds) back in 1985 and proceeded to learn the hard way when he drank his way out of a scholarship to Tulane later that year. After a few years of sweating for a living, he decided to go back to school, and graduated from LSU-Shreveport in 1995 with a Bachelors in Mathematics - all the while working the overnight shift stocking shelves in a grocery store.

Post-college, Bill has been in the P&C insurance industry as an actuary, product manager, and pricing manager. Bill and his wife Millie are amateur investors with a variety of holdings, but they prefer to buy and hold value investments. In typical "value" style, they live cheap, driving old cars and preferring to save or invest instead of buying fancy "stuff."

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.


In my May 2008 guest commentary, I took a look at some ideas for screening small cap value stocks.  It is now time to revisit those ideas, with an eye towards improving them. The screen I tested as a mechanical process, trading out stocks based on a once-monthly screening, looked like this:

I will use three valuation metrics, and demand that the stock is cheaper than its industry group average in all three: Price/Earnings, Price/Book, and Price/Sales.

I will use four fundamental metrics, three of which are taken up by demanding the stock have positive Earnings over the last 12 months, have a positive Book Value in the most recent quarter, and have positive Sales/Revenues over the last 12 months.  Additionally, I demand that the stock have a positive Return on Assets, and that its ROA be better than its industry group average.

Since this is intended to be a small-cap value screen, I will limit myself to exchange-traded stocks above $100 million (no micro-caps or over the counters) and sort all qualifiers Ascending by Market Capitalization, giving preference to the smallest companies first.

In Keelix terminology, it will look like this:

Keep :OR([SI Exchange]="N",[SI Exchange]="A",[SI Exchange]="M")
Keep :[SI Market Cap Q1]>100
Keep :[SI PE]>0
Keep :[SI Price/Book]>0
Keep :[SI Price/Sales]>0
Keep :[SI Return on assets 12m]>0
Keep :[SI PE]<[SI Ind. PE]
Keep :[SI Price/Book]<[SI Ind. Price/Book]
Keep :[SI Price/Sales]<[SI Ind. Price/Sales]
Keep :[SI Return on assets 12m]>[SI Ind. Return on assets 12m]
Sort Ascending [SI Market Cap Q1]

As you may remember, the best results were obtained by holding 20 to 50 of the stocks at one time; this is a trade-off between capitalization on the "small-cap" effect and the fact that too narrow a selection based on small cap size results in winners rapidly outgrowing the screening criteria!

My first task is to update the returns for many of the screens presented earlier.  It's been a bad couple of months for value-based traders.  These all have lower Cumulative Annualized Growth Rates (CAGRs) than the last test, but the pattern remains the same, with holding 20 to 50 stocks - impractical for most retail traders - providing the best result.  (Turnover% is per each rescreening).

Test Start Test Stop # Held Hold Period (Days) CAGR Turnover% Sort Order
08/31/97 07/11/08 100 28 15% 30 Smallest Cap Size
08/31/97 07/11/08 50 28 18% 37 Smallest Cap Size
08/31/97 07/11/08 20 28 17% 53 Smallest Cap Size
08/31/97 07/11/08 10 28 11% 66 Smallest Cap Size

My first revisit is one I promised earlier, and that was to get even lazier, and rescreen only once/quarter, or once/six months, with 10 or 20 stocks, the way a lazy retail trader might do it.  I expected that this method would provide better results, because the longer holding period would allow winners to run, but I was pleasantly surprised by the outcome. 

Test Start Test Stop # Held Hold Period (Days) CAGR Turnover% Sort Order
08/31/97 02/20/08 20 182 15% 84 Smallest Cap Size
08/31/97 02/20/08 10 182 26% 90 Smallest Cap Size
08/31/97 05/23/08 20 90 21% 73 Smallest Cap Size
08/31/97 05/23/08 10 90 21% 83 Smallest Cap Size

Note, however, the staggered end time that comes from starting different-length tests on the same date.  Until I reverify the quarterly and semiannual processes with a time period that matches start and end times of the monthly process, I'm reserving full judgment on this result.

I was wondering how the criteria in general (triple-cheap, good ROA, positive earnings) would work as a BIG-cap value screener.  So I re-ran the tests holding the 10, 20, 50, and 100 LARGEST stocks by capitalization, where they otherwise met criteria.

Test Start Test Stop # Held Hold Period (Days) CAGR Turnover% Sort Order
08/31/97 07/11/08 100 28 12% 27 Biggest Cap Size
08/31/97 07/11/08 50 28 9% 29 Biggest Cap Size
08/31/97 07/11/08 20 28 7% 30 Biggest Cap Size
08/31/97 07/11/08 10 28 6% 34 Biggest Cap Size

What's interesting is the relative performance of this screen vs. the major indices; the Russell 2000 has returned around 4% CAGR over the test time period, and even continuously holding only the 10 largest qualifiers outperformed the RUT.  Working this in size, the way an institution might, by holding the 100 largest qualifiers would not only have significantly outperformed any domestic stock benchmark (12% CAGR not counting expenses or adding dividend gain, over almost 11 years), it would also be HIGHLY scaleable. 

My first really counterintuitive test result came from sorting the qualifiers by return on equity (ROE), descending.  At the extremes, it's actually counterproductive (hence counterintuitive). 

Test Start Test Stop # Held Hold Period (Days) CAGR Turnover% Sort Order
08/31/97 07/11/08 100 28 18% 29 Best Return on Equity
08/31/97 07/11/08 50 28 16% 31 Best Return on Equity
08/31/97 07/11/08 20 28 8% 35 Best Return on Equity
08/31/97 07/11/08 10 28 4% 40 Best Return on Equity

My only thought on the causation is that, perhaps, really really high ROE is a relatively random event, and without the protection of also screening for earnings quality, holding the very highest ROE stocks weights the portfolio towards companies that can't repeat that earnings performance.  I say this because my experiments with high ROE in combination with earnings quality screens have been pretty successful, and because the more high ROE stocks are held (hence the lower the ROE cutoff for holding), the better the returns.

My final thought was to perform the final sort based on trailing twelve-month momentum; combining momentum with valuation is an old strategy, around since rocks were soft - or at least since Marty Zweig. 

Test Start Test Stop # Held Hold Period (Days) CAGR Turnover% Sort Order
08/31/97 07/11/08 100 28 19% 37 Best 12m Momentum
08/31/97 07/11/08 50 28 21% 42 Best 12m Momentum
08/31/97 07/11/08 20 28 25% 48 Best 12m Momentum
08/31/97 07/11/08 10 28 22% 53 Best 12m Momentum

This seems like a mechanical strategy possibly suitable for the average retail trader, generating robust results with holdings of 10 to 20 stocks on 60 to 120 trades a year - not a terrible drag on returns with a size around $100K + and a good discount broker.  The only strategies that came close in test were the long holding periods on small market cap sorts, and as mentioned, I need to redo those with exactly-matching timeframes.  The disparity between the performance of holding 10, vs. holding 20, for 182 days also points to a possible problem in those test results.

Test Start Test Stop # Held Hold Period (Days) CAGR Turnover% Sort Order
08/31/97 02/20/08 10 182 26% 90 Smallest Cap Size
08/31/97 07/11/08 20 28 25% 48 Best 12m Momentum
08/31/97 07/11/08 10 28 22% 53 Best 12m Momentum
08/31/97 05/23/08 10 90 21% 83 Smallest Cap Size
08/31/97 05/23/08 20 90 21% 73 Smallest Cap Size
08/31/97 07/11/08 50 28 21% 42 Best 12m Momentum
08/31/97 07/11/08 100 28 19% 37 Best 12m Momentum
08/31/97 07/11/08 100 28 18% 29 Best Return on Equity
08/31/97 07/11/08 50 28 18% 37 Smallest Cap Size
08/31/97 07/11/08 20 28 17% 53 Smallest Cap Size
08/31/97 07/11/08 50 28 16% 31 Best Return on Equity
08/31/97 07/11/08 100 28 15% 30 Smallest Cap Size
08/31/97 02/20/08 20 182 15% 84 Smallest Cap Size
08/31/97 07/11/08 100 28 12% 27 Biggest Cap Size
08/31/97 07/11/08 10 28 11% 66 Smallest Cap Size
08/31/97 07/11/08 50 28 9% 29 Biggest Cap Size
08/31/97 07/11/08 20 28 8% 35 Best Return on Equity
08/31/97 07/11/08 20 28 7% 30 Biggest Cap Size
08/31/97 07/11/08 10 28 6% 34 Biggest Cap Size
08/31/97 07/11/08 10 28 4% 40 Best Return on Equity

Patience ... or momentum?  Interesting choice.

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