AAII Stock Ideas: Oberweis Octagon Strategy
Today I cover the Oberweis Octagon stock-picking strategy and send you a list of stocks that currently pass our screen based on the approach. The Oberweis Octagon strategy focuses on small and mid-sized firms that meet eight criteria for value, growth and momentum. For the patient investor with the ability to withstand the higher short-term volatility and risk of small- and mid-cap stocks, there is the potential for strong long-term returns.
As of November 30, AAII’s Oberweis Octagon screening model has an annual gain since inception (1998) of 11.4%, versus 7.9% for the S&P SmallCap 600 index and 8.5% for the S&P MidCap 400 index in the same period.
Investing in Small Companies Using the Oberweis Octagon Screen
The coronavirus pandemic, while better understood than it was at the beginning of the year, still presents significant uncertainty in terms of how it will impact society and the economy. Despite the long-term uncertainty, positive preliminary vaccine and antibody treatment news in November from major pharmaceutical companies led to a feeling of optimism among investors.
Small- and mid-cap stocks showed their potential in November with the S&P SmallCap 600 up 18%, while the S&P MidCap 400 rallied 14.1%. The S&P SmallCap 600 is up 1.3% year to date through November 30, while the S&P MidCap 400 is up 7.9%.
The AAII Oberweis Octagon strategy seeks rapidly growing small to mid-size companies trading at attractive prices — a process that Oberweis Asset Management, an independent investment management firm, terms “AGARP”: aggressive growth at a reasonable price. The AAII Oberweis screening strategy integrates value, growth and momentum factors stemming from eight points that make up the Oberweis Octagon including:
- Rapid annual growth in revenue (sales)
- Rapid annual growth in pretax income
- “Favorable” recent (quarterly) trends in revenue and earnings growth, ideally showing acceleration
- Low price-earnings ratio in relation to underlying growth rate
- Low price-to-sales ratio
- Strong price strength relative to the market
- Products or services that offer the potential for strong future growth
- Review of company financial statements, especially the footnotes, to attempt to identify future problems
The Oberweis Octagon screen seeks to identify and capitalize on pricing inefficiencies involving small to mid-size companies experiencing rapid growth. The Oberweis approach begins by limiting the universe of stocks to exchange-listed micro-, small- and mid-cap companies. Exchanges have listing requirements that establish minimums for company size, share availability and financial strength.
The AAII Oberweis screen focuses on “small” companies with market capitalization (stock price multiplied by number of shares outstanding) under $1 billion and “medium” companies between $1 billion and $8 billion. There are specific criteria applied to these two groups of companies.
By focusing on smaller companies, the Oberweis approach is attempting to find companies with a greater potential for high growth. No company can sustain a high growth rate indefinitely — eventually its size begins to weigh it down. Large companies simply cannot sustain the high growth rates that smaller, fast-growing companies can.
It is important to point out that there are unique risks to investing in small companies. Some of these risks include limited product lines, markets and financial resources. Furthermore, the stocks of small companies tend to be more thinly traded than the stocks of larger, more established companies. Therefore, the prices of these stocks can be subject to sudden and significant movements.
Growth in Revenues and Earnings
Rapid and consistent growth, specifically in revenues and earnings, stands as the cornerstone of the Oberweis Octagon approach. Sales are important because they drive bottom-line growth (earnings), and because sales tend to be more difficult to manage or manipulate than earnings. The AAII Oberweis screen seeks small companies with a market capitalization below $1 billion to have growth rates in sales and pretax income over the last 12 months of at least 30%, while requiring medium-sized companies with a market cap between $1 billion and $8 billion to be growing sales and pretax income at a rate of at least 20% over this same period.
Early Earnings Acceleration
One of the goals of the Oberweis Octagon strategy is to identify rapidly growing companies in the early stages of their life cycles which, in turn, will generate excess long-term returns.
The screening criteria focusing on “favorable” trends in earnings and sales require that both sales and earnings per share from continuing operations for the last fiscal quarter be greater than they were for the same quarter one year prior. Furthermore, sales and earnings from the prior fiscal quarter must also be greater than they were for the same quarter one year prior.
Looking at the annual results for a company, the screen also requires that sales and earnings per share from continuing operations for the last four quarters (12 months) be greater than they were for the last fiscal year.
Value Elements: Low Relative Price-Earnings Ratio and Low Price-to-Sales Ratio
Identifying rapidly growing companies with prospects for continued growth in the future is only part of the Oberweis stock selection methodology. From the universe of aggressively growing companies, the strategy seeks out those that are reasonably priced. Specifically, the AAII Oberweis screen looks at stock market valuations — especially the price-earnings and price-to-sales ratios.
To isolate reasonably priced companies from the universe of rapidly growing firms, the Oberweis Octagon screening methodology makes use of a modified PEG ratio that compares the price-earnings ratio to the projected growth rate in earnings for the next year, which is the percentage change of forecasted earnings for the current fiscal year compared to the level of reported earnings for the last fiscal year.
For smaller companies the Oberweis screen requires the price-earnings ratio to be less than the estimated growth rate in earnings per share, while for medium-sized companies the price-earnings ratio cannot exceed the projected one-year growth rate in earnings per share.
The other value element of the Oberweis approach considers the price-to-sales ratio. This ratio looks at the current stock price to the sales of a company. The Oberweis Octagon methodology considers companies with reasonable price-to-sales ratios based on the company’s underlying growth prospects and profit margins. For this screen, a company’s price-to-sales ratio is compared to that of its industry. The screen requires that the current price-to-sales ratio be less than the median value of the price-to-sales ratio for the respective industry.
Strong Price Strength Relative to the Market
Research confirms the benefit of seeking out stocks with high relative strength, especially when combined with other fundamental selection characteristics, such as size and value. Momentum is not merely for short-term traders and those who rely on technical analysis, but also for those who focus on fundamental analysis.
Price momentum is normally measured by comparing the price change of a stock over a specified period relative to a benchmark, such as the S&P 500 index, or against a segment of stocks; the resulting number is called relative strength.
The Oberweis approach looks for companies that have outperformed at least 75% of the other stocks in the market over the last 12 months. Therefore, the Oberweis screen requires a company to have a 52-week relative strength figure that ranks in the top 25% of stocks.
Future Growth Potential
While the AAII Oberweis Octagon stock selection process is relatively “mechanical,” Oberweis Asset Management incorporates two additional elements into its selection process that are subjective in nature. The AAII Oberweis approach does not consider these subjective elements in its screen.
One of these subjective elements involves identifying the future growth potential of a company — specifically, focusing on companies with products or services that offer the potential for “substantial” future growth. This element can be thought of as a company possessing a durable competitive advantage over its competitors that allows it to protect its market share and profitability.
Another way in which the Oberweis methodology looks to the future is through careful examination of a company’s financial statements. Specifically, Oberweis Asset Management reviews a company’s quarterly and annual reports filed with the U.S. Securities and Exchange Commission (SEC), paying close attention to the footnotes that accompany these filings to attempt to identify future problems or threats.
The footnotes serve to augment the information provided in the financial statements and contain supplemental data and disclosures. Footnotes provide information about the accounting methods used as well as management’s underlying assumptions and estimates. Disclosures found in the footnotes typically relate to areas such as fixed assets, inventories, pension and other post-employment benefit plans, lawsuits and other contingencies, marketable securities and other investments and significant customers and sales to related parties.
The AAII Oberweis screen cannot assess these two elements via a mechanical screen. This point underscores the need for additional analysis once you have applied any type of mechanical screen to a universe of stocks.
The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.
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