AAII Stock Ideas: Stocks Powering AAII’s Top Strategy of 2020

Tomorrow’s Future Market Heavyweights

Small-cap companies have long captured the attention of investors looking for tomorrow’s market heavyweight. However, with thousands of small caps out there, finding the most promising firms that warrant further research is a daunting task.

Stock screening allows you to narrow the universe of companies down to a more manageable group that you can then analyze more closely.

The attraction of small caps is their potential to become large companies, with their share price growing in the process. However, the risks — the greatest of which is that they fail — eliminate them from consideration by many individual investors.

Small-cap companies also do not garner the attention of the financial media or analysts that larger firms do. However, the Foolish Small Cap 8 strategy is partly based upon the premise that the lack of coverage and interest in small-cap companies presents a better opportunity to locate undiscovered, attractive investment candidates.

The strategy uses eight criteria to look for profitable and rapidly growing small companies with strong price momentum.

The Foolish Small Cap 8 screen was designed to flag potential growth companies based upon a combination of market- and business-related factors. The filters used to identify good businesses are as follows:

  • Share price of at least $7; and
  • Relative strength greater than 90%.

No Laughing Matter: Stocks Passing the Foolish Small Cap 8 Screen During 2020

In 2020, 11 stocks passed the screen between the end of 2019 and the end of December 2020. Furthermore, at least one company passed the screen each month, except for April 2020. The Foolish Small Cap 8 screen’s 2020 performance was no laughing matter, up 142.5%. The companies driving the screen’s 2020 performance are listed in the table below.

When following a given strategy, spreading your investment around into more stocks will lower your volatility, as investing in a small number of companies makes a portfolio more susceptible to individual stock price movements.

Small Companies

The most common method of analyzing companies based upon size is market capitalization — current price per share times the number of shares outstanding for the company.

However, for the Foolish Small Cap 8 screen, small companies are defined as those that have sales over the last four quarters (trailing 12 months) of $500 million or less. This screen is designed not only to separate the small from the large, but also to orient the investor’s mind toward purchasing a company, rather than a small-cap stock.

Growth

One advantage of focusing on smaller companies is that they tend to have a greater potential for high growth. It is much easier for a smaller company to grow earnings and sales. No company can sustain a high growth rate indefinitely — eventually its size begins to weigh it down.

The Foolish Small Cap 8 methodology looks for a minimum level of year-on-year growth in both sales and earnings from continuing operations — which excludes extraordinary items and discontinued operations — of at least 25%. The screen is looking for quality small companies and instituting such a high growth requirement is one way of achieving that goal.

Net Profit Margin

Net margin, the focus of the next Foolish Small Cap 8 small-cap screen, is the bottom-line profit margin that indicates how well management has been able to turn sales into earnings available for shareholders. It is computed by dividing net income by sales for the same period. Here, the screen looks for companies with a net margin of 7% or greater for the trailing 12 months. Since profit margins are in part affected by the industry in which a company operates, it is common to compare the margins of a company to those of its underlying industry or sector.

Low Liquidity

One risk of investing in smaller companies is that their shares tend to be illiquid — the trading volume of the shares is low, and the spread between the stock’s bid and ask prices is high. If you own an illiquid stock and wish to sell it, you may have to discount the price to attract a buyer. Common screening strategies to avoid illiquid shares include requiring a minimum level of trading volume or a minimum level of shares outstanding.

As a proxy for liquidity, the Foolish Small Cap 8 screen makes use of average daily dollar trading volume. Volume is the total number of shares transacted. The daily average can be calculated using various time periods, but a daily average based on three months’ trading is common. Average daily dollar volume reflects the current price of a stock multiplied by its average daily volume. In order for a company to pass the Foolish Small Cap 8 screen, its average daily dollar volume must be between $1 million and $25 million.

Insider Holdings

For the Foolish Small Cap 8 screen, AAII looks for companies where insiders own at least 10% of their company’s stock. This requirement allows investors to see whether the interests of “insider” shareholders are aligned with those of “outsider” shareholders.

As a general rule, it is better that a company have some level of insider ownership than not. Who else would better know the future prospects of the company and how this may affect future stock price movement? In order for a company to pass the Foolish Small Cap 8 screen, the percentage of insider ownership must be greater than 10%.

Price & Performance

While the Foolish Small Cap 8 screen seeks attractive small companies, it does not want these companies to have a price that is too low. As a rule, The Motley Fool shies away from so-called penny stocks, which it terms as stocks with a price per share of under $5. These companies, historically, have been prone to manipulation, as well as a lack of financial data. In looking at share price, the Foolish Small Cap 8 screen raises the price requirement to $7 per share or greater.

Just as price reflects certain fundamental aspects of a company, so too does relative price strength. High price performance relative to the stock universe tends to show that the market is recognizing the company’s value and is driving up the price of the stock at a rate better than that of a majority of other stocks. Therefore, AAII’s version of the Foolish Small Cap 8 screen requires that a company’s relative strength 52-week percentage rank value be 90% or greater. In other words, over the last 52 weeks the stock has performed in the top 10% of AAII’s entire stock universe database.

Conclusion

Stock screening such as this is a useful way of identifying potential investment candidates. However, AAII stresses that the final list of companies passing its Foolish Small Cap 8 screen — or any list of passing companies you generate — is by no means a buy list. It is up to you to perform your own due diligence to see whether the companies truly warrant your investment dollars.

This is especially true when dealing with small companies, where the price of making a mistake tends to be greater than when dealing with larger firms.

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