I’m often asked how I screen for small cap stocks. Most of my formal screens are broad-based and only include a market cap and profitability filter. Specifically, I require a $100 million to $5 billion market cap and a 1% return on equity (ROE). Although a 1% ROE hurdle may seem inadequate, considering the high number of unprofitable small cap companies, even low profitability requirements can be effective in eliminating many lower quality candidates. In fact, depending on where we are in the profit cycle, I’ve found a third to a half of small cap stocks are kicked out of my screens once profitability is required. Another reason I keep profitability hurdle rates low, is I want to avoid kicking out high-quality cyclical companies generating trough operating results (also why I rarely screen on P/E). In general, when screening, I want to be as inclusive as possible and avoid becoming a Grey Poupon Investor.
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After screening for market cap and profitability, I attempt to weed out companies with inadequate financial strength and liquidity. Specifically, I discard companies with debt levels above 3-5x discretionary cash flow (depending on the cyclicality of the business). I want to be extremely careful to never find myself at the mercy of a fickle banker or an emotional bond market. After finishing my balance sheet screening, I toss out companies I’m familiar with that I refuse to own for one reason or another (management, strategy, industry, capital allocation, etc.).
Once my screening process is complete, I’m usually left with approximately 500 small cap stocks, with many already on my possible buy list. On average, I discover one or two new ideas a month. These ideas are initially placed on my possible buy list and rarely go into the portfolio immediately. I like to follow new buy list names for at least six months before purchasing. I want get to know the businesses well before allocating capital. Furthermore, I want to avoid making valuation errors resulting from inaccurate first impressions. Are you familiar with that exciting feeling you receive shortly after uncovering a great investment idea? That’s an emotion — be careful. Your excitement could cause you to jump to conclusions you want to be true. I like to fight this urge with time, walks, and further thought.
In addition to my formal screening process that sorts through a large portion of the small cap market, I also like to run focused screens on out of favor sectors. Excessive pessimism within an industry can create tremendous opportunity. Examples include energy in 2009 and precious metal miners in 2014-2015. During these severe sector bear markets, I ran industry screens searching for companies that had an above average probability of surviving their industry’s recession. Screening for and assessing financial risk was critical. While it’s nice buying an attractively priced stock, if the balance sheet isn’t strong enough to survive the cycle, large discounts to value and margins of safety can quickly become irrelevant.
How do I determine what sectors are most out of favor? One of my favorite methods is role-playing. Specifically, I like to put myself in the shoes of a highly-paid relative return manager running billions of dollars. I pretend to own a luxurious house, fancy cars, vacation homes, and a big boat (maybe with a helicopter, maybe). I’m living the dream. I then envision year-end is approaching and I’m heading down the stretch of the performance derby. It’s bonus determination time! Finally, I imagine I’m about to have a dozen client meetings with some of the country’s largest investment consultants. My relative performance has been average and I’m aware the AUM in my fund is at risk. I then ask myself, what stocks and sectors do I want to avoid owning and discussing during my upcoming meetings? And what area of the market would be too big of a drag on near-term performance and too risky to own from an AUM perspective? Answer these questions and you’ll often find elevated perception risk and the most undervalued sectors of the market.
Where is perception risk highest today? While not as disliked as energy in 2009 and the miners in 2014-2015, I believe retailers and energy are two areas relative return investors appear to be avoiding. How many relative return investors want to own under-performing retailers and energy stocks heading into year-end? I’m not sure, but in my game of pretend, I sure don’t!
Now back to reality. As an absolute return investor, I love bear markets, even if they’re isolated to specific stocks or sectors. As year-end relative performance anxiety mounts, I’m hopeful the selling pressure in retail and energy continues and possibly intensifies. I’m optimistic and ready.
Article by Absolute Return Investing with Eric Cinnamond
