Welcome to the inaugural issue of Investing Daily’s new small-cap stock investment service: Roadrunner Stocks. As the chief investment strategist of this publication, I’m eager to convey to you the exceptional wealth-building opportunities of high-quality small-cap and mid-cap stocks. It’s an empirical fact that virtually all investors should allocate a portion of their investments to small-cap and mid-cap stocks.

What is a Small-Cap Stock?

Micro-cap: under $250 million (median size = $170 million)

Small-cap: Between $250 million and $3 billion (average size = $1.3 billion)

Mid-cap: Between $3 billion and $10 billion (average size = $8.8 billion)

Large-cap: Above $10 billion

If you invest mainly in the S&P 500, your exposure is limited to large-cap stocks since the index has an average market cap of $28.2 billion. Actually, since the index is capitalization weighted—as opposed to equal weighted—your equity exposure is even more tilted to large cap since the weighted average market capitalization is $106.5 billion.

Small-Cap Asset Allocation

Small and mid-cap stocks comprise about 20 percent to 25 percent of total stock market capitalization (page 4), so a market-neutral exposure requires that a similar percentage of your personal equity portfolio should be allocated to small and mid-caps. Because of recent evidence that large-cap stocks are dangerously correlated with each other, some financial planners recommend that well-diversified equity portfolios have an overweight allocation to small-caps (e.g., between 25 percent and 35 percent), which exhibit less inter-stock correlation than large caps and thus offer superior diversification benefits.

One theory for why large-caps have become so highly correlated is because it has become increasingly popular for institutional investors (e.g., mutual funds) to trade large-cap stocks collectively as an asset-class basket (i.e., risk on or risk off) thanks to the explosion in trading of large–cap exchange-traded funds like the SPDR S&P 500 ETF (NYSE: SPY).  

Whatever the reason, small-cap stocks perform in a much more individualistic manner than large caps, and consequently hard-nosed fundamental and technical research makes a really significant difference in the small-cap space. It is critical to separate the high-performing wheat from the poor-performing chaff because academic studies have found that a majority of small caps actually underperform the general market.

The upshot: Buying a small-cap index fund won’t work; the key to success in small-cap investing is isolating the winners and investing in them only.

Safety First

I have developed a six-point “safety rating” system for Roadrunner subscribers that steers us away from stocks exhibiting risky characteristics that historically have led to problems down the road. Each recommended Roadrunner stock will be assigned a safety rating, which will be prominently displayed on the portfolio page of the website.

A description of each component of the safety rating system is also a permanent fixture under the Resources menu on the Roadrunner website because I am convinced safety is that important.

Quality Ensures Safety

Why is it so important? Because it turns out that avoiding losers is the main determinant to investing outperformance and the best way to avoid losing stocks is to focus on quality. The definition of “quality” includes criteria such as low debt, high earnings profitability, persistent free cash flows, and revenue growth.

Stocks with such characteristics should exhibit relatively low stock volatility—especially of the downside variety. James O’Shaughnessy, author of the investment classic What Works on Wall Street, recently performed a 47-year study comparing the relative annualized performance of high-quality and low-quality value and momentum stocks. The results were striking:

Importance of Quality

Annualized Returns: 1963-2011

Source: O’Shaughnessy Asset Management

An annualized outperformance of 5% translates into huge differences in wealth generation over time. If you recall, in your Small-Cap Wealth Builders premium report, I presented a table showing the greater wealth accumulation possible from investing in small-cap value stocks compared to large-cap growth stocks:

Over an 83-year period, a 5.3 percent annualized enhancement (14.1 percent vs. 8.8 percent) resulted in a portfolio size that was 49 times larger.

Small is Beautiful

These stock-performance differentials—whether it be based on quality, value, or momentum—make a huge difference in investment returns, which is why the investment philosophy of Roadrunner Stocks is geared towards exploiting this academic research for my subscribers’ benefit. The core foundational principle of my service is that small-cap stocks outperform large-cap stocks. As legendary Fidelity mutual fund manager Peter Lynch famously said:

Big companies have small moves, small companies have big moves.

Intuitively, this makes sense based on the law of large numbers. It’s much easier to grow 50 percent to 100 percent per year when starting from a small base than it is when starting from a large base. Investing in the next Wal-Mart Stores (NYSE: WMT) won’t happen by investing in Wal-Mart itself. Otherwise, large-cap companies with $100 billion-plus market caps would quickly grow larger than the economy itself!

But investing in small-cap stocks is just the start. When you combine the foundational principle of small-cap investing with these other outperforming factors (e.g., value and quality, value and momentum, momentum and quality), the investment results are even more powerful.

Six-Point Safety Rating System

The first step in this combination process is my six-point safety rating system, which I outlined in The Small-Cap Blacklist premium report. To repeat, for each of the six measures, a stock gets one point if it exceeds a threshold level. A score of 6 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.

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. He found that the small-cap value stocks with the strongest fundamentals (i.e., highest F-scores) significantly outperformed those with weak fundamentals and low F-scores.

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.

Indiana University Accounting 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 in order to earn a safety point.

3. Altman Z-Score of 3.5 or above

NYU Finance Professor Edward Altman developed a five-criterion 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. Short Interest to Float Ratio 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 percent per year). To qualify for the 99th percentile, the stock typically has a short interest ratio of 20 percent or higher. I only give a safety point if a stock’s short interest ratio is less than 10 percent.

5. 10 Percent 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 percent 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) so, 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.

The Holy Gail of Investing: Value and Momentum

Small-cap investing comes in two varieties—growth/momentum and value. Growth/momentum stocks sport premium valuations—e.g., high price-to-earnings (P/E) ratios—and hover near their 52-week high prices. These companies are typically 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 are cheap because the underlying company’s business has not done well lately. Patience is required, but further downside is probably limited and the payoff will likely be larger if the business recovery comes.

Academic research has found that a combined portfolio of 50 percent value stocks and 50 percent 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 of -0.65 with each other (best possible is -1.00). This negative correlation makes sense because momentum works when price continues in the same direction and value works when price reverses.  Negative correlations within a portfolio reduce downside volatility and smooth out returns. 

Two Roadrunner Portfolios: Value and Momentum

Based on this research, Roadrunner Stocks has two small-cap portfolios: one value and one momentum. At launch, we are starting the portfolios with five stocks each. Every month, a new stock will be added to each portfolio until a total of 20 stocks per portfolio has been reached. Reasonable portfolio diversification requires at least 20 stocks and preferably double that number.

At the same time, small-cap stocks constitute only a minority of most investors’ equity portfolios, so it is not practical to expect Roadrunner subscribers to buy more than 40 small-cap stocks. I think it important to cap the size of these portfolios and, once they reach a certain size, require that any recommended purchase be counterbalanced by a recommended sale so that the portfolio size does not continue to grow.

For value, I will use the enterprise value-to-EBITDA ratio as my primary criterion because it has historically done a better job at predicting future stock performance than other value measures such as P/E. Although the ranges of EV-to-EBITDA ratios differ by industry, a general rule of thumb is that any ratio under 9.5 is cheap.

Since value stocks are often cheap because of current (but hopefully temporary) business problems, the safety rating as a guard against financial problems is probably more important for the value stocks than it is for the momentum stocks. Momentum stocks, after all, are typically already performing well operationally. Among the safety-rating components, Piotroski F-Score and Altman Z-Score are more relevant to value stocks; Beneish M-Score and Beta are probably more relevant to momentum stocks.

For momentum, I will focus on three momentum metrics: (1) earnings and revenue growth rates; (2) closeness of current stock price to its 52- week high; and (3) the “flare-out growth” price momentum formula developed by Ford Equity Research of San Diego:

12-month percentage price appreciation minus 3-month percentage price appreciation minus 3 times the 1-month percentage price appreciation.

The theory behind this formula is that it will generate a list of stocks with bullish flag or pennant chart patterns—strong upward momentum that has temporarily flat-lined before it resumes its uptrend. By penalizing short-term price appreciation, the screen guards against buying stocks that have recently run up in price to a peak level and which may soon reverse back down out of sheer buyer exhaustion.

Momentum stocks typically exhibit both earnings momentum and price momentum, but sometimes they exhibit only one of the two kinds. I reserve the right to select stocks of either type of momentum in isolation, but most best-performing momentum stocks exhibit both kinds.

Although I expect optimal investment results to involve purchasing all Roadrunner recommendations—value and momentum—Roadrunner members should keep in mind that stocks in the momentum portfolio will be much more volatile than the stocks in the value portfolio and the “win rate” of momentum recommendations will probably be lower as well.

Furthermore, by definition, momentum stocks have already had a substantial run of good fortune, so while near-term continuation of upward price movement is likely, the sustainability of the bullish trend may be limited.

I have tried to maximize sustainability by focusing on stocks near 52-week highs, since academic research has found that momentum based on 52-week highs lasts longer than momentum based on 12-month price appreciation.

Nevertheless, I expect the momentum portfolio to experience a much higher degree of trading (buys and sells) than the value portfolio. Conservative investors who cannot tolerate frequent trading and a lower win rate should consider focusing more (or exclusively) on the value portfolio.

Welcome Aboard

You are poised to embark on an exciting small-cap investment journey; I will serve as your guide. Your trip promises to be profitable, as well as educational. Each article on the Roadrunner website has room at the bottom for you to submit your comments; I want to swap investing insights with readers and foster highly interactive, give-and-take discussions on the merits of each Roadrunner stock recommendation.

Let the journey begin!

Jim Fink, chief investment strategist