The 2018 All Star small caps: How we found them - MoneySense

The 2018 All Star small caps: How we found them

Methodology: What makes a small cap a MoneySense All Star?

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We’re pleased to present the fourth edition of the Small Cap 500.  Join us as we dive into the U.S. market to find the most promising small stocks in the land.  Each stock is scrutinized and ranked based on its value and growth characteristics.  The firms that score highly on both tests make it into our All Star team.

We have high expectations for the pint-sized firms because small stocks have generated outsized returns for investors according to Dartmouth professor Kenneth French.  In one study he sorted U.S. stocks into three groups by size as measured by market capitalization (a stock’s price times its share count). Each group was tracked for a year and then the process was repeated. As a result, he was able to calculate how small, medium, and large stocks fared over the years.

The smallest 30% of stocks performed the best with average annual gains of 12.0% over the 90 years from the start of 1927 through to the start of 2017. The middle group did nearly as well with annual returns of 11.7%. But size proved to be a liability for the largest 30% of stocks, which generated gains of 9.6% annually.

As it happens, our All Star stocks (those that earned at least one A and one B for their appeal as value and growth investments) provided average annualized returns of 11.8% since we started back in the spring of 2014.  By way of comparison, the Russell 2000 index, which tracks 2000 small U.S. stocks, climbed at an annual rate of 8.3% over the same period.  The All Stars beat the small-stock index by an average of 3.5 percentage points per year.

Small stocks surged since our last update with the All Stars rocketing up 58.1% since the spring of 2016.  The big gains reflected a general advance by small stocks because the Russell 2000 also climbed by 58.1% over the same period.  However, large stocks – as represented by the S&P 500 index – lagged with gains of 46.2% since the spring of 2016.

Small stocks should continue to fare well over the long term, but there will be some big ups and downs along the way.

Defining Small

Our search for the best small stocks starts with the universe of all U.S. stocks (the Canadian small cap market is too small to do this same approach).  To avoid penny stocks we stick to those that trade for more than $1 per share.  (All figures in U.S. dollars.)  We also demand revenues (over the last 12 months) and market capitalizations in excess of $200 million.  That might sound like a lot to you and me, but $200 million is small potatoes for companies that trade on the New York Stock Exchange.  We also require at least a year’s worth of trading history and we do our best to remove firms that are currently subject to takeover offers.

The smallest 500 stocks that remain, based on market capitalization, are ranked and graded.  You can find them all in this year’s giant table of small caps, which uses data from Bloomberg.

To get a sense of scale, Hallmark Financial Services (HALL) is the smallest stock this year with a market capitalization of $201 million. The largest is Infinity Property & Casualty (IPCC) with a market capitalization of $1.2 billion.  If our suspicions are correct, you probably haven’t heard of either one.

Grading for Growth and Value

Every stock is first evaluated for its growth potential. Those with the best records are awarded As, the next best get Bs, and so on, all the way down to Fs for those in need of improvement. Every stock is then graded based for its merit as a value investment. The best bargains get As while expensive stocks take home Fs.

To get top marks each stock must pass the same series of strict tests that we use for the large-cap U.S. All Stars  and Canadian All-Stars. On the growth side, we favour firms that have increased their sales-per-share and earnings-per-share at a reasonable rate. We also like strong returns on equity, above average market performance over the last year, and low-to-moderate price-to-sales ratios. On the value front, we appreciate stocks selling at modest price-to-book-value ratios compared to their peers and to the markets overall. We view high-debt loads with suspicion and give extra points to profitable ventures that pay dividends. To get to the top of the class a stock should ideally possess all of these qualities.

The very best prospects get a coveted double-A rating, which makes them outstanding growth and value candidates. But we think stocks with at least one A and one B on the value and growth tests are well worth your consideration.  They form the All Star team.

A Caveat

Before you load up on small stocks, be aware of the risks. While we think our top stocks have what it takes to be successful, the future is far from certain and some of them will inevitably disappoint. That’s why it’s best to build a broadly diversified stock portfolio that balances small stocks with large stocks.

But we think our small stock guide is a great place for you to start your search for profitable investments.  It’s packed full of information to help you find the best opportunities. So, use the tabs at the top of this story to jump over to the big data table that contains information on all 500 stocks, check out this year’s All Star lineup, or look back to see how last year’s All Stars fared.