Find the Next Apple Using
Momentum: 5 Hidden Gems
Promising Sensational
Small-Cap Success
Jim Fink
The Wealth Summit
May 2014
Small-Cap Value Outperforms
“Big companies have small moves, small companies have big moves.”
-- Peter Lynch, Fidelity Magellan
Over an 86-year period, a 5.2 percent annualized enhancement (15.1
percent vs. 9.9 percent) resulted in a portfolio size that was 53 times
larger.
Equity Style
Compound Annual Return $1 Invested in 1927
(1927-2013)
Worth in 2013
Small-Cap Value
15.1%
$178,845
All Small Cap
12.1%
$18,454
Large-Cap Value
12.0%
$17,090
All Large-Cap
9.9%
$3,356
Long-Term Gov’t Bonds
5.5%
$100
What is a Small-Cap Stock?
• Small-cap: Between $250 million and $3 billion
• Mid-cap: Between $3 billion and $10 billion
• Large-cap: Above $10 billion
– S&P 500: Average Market Cap of $28.2 billion.
Weighted average market capitalization is $106.5
billion.
Recent Relative Annualized Returns
(as of 12/31/2013)
Time Period
Small Caps
Mid Caps
Large Caps
1 Year
38.8%
34.8%
33.1%
3 Years
15.7%
15.9%
16.3%
5 Years
20.1%
22.4%
18.6%
10 Years
9.1%
10.2%
7.8%
15 Years
8.4%
9.2%
5.1%
Small Caps Safer Than Large Caps
Over Longer Time Frames
(12/31/1939–12/31/2013)
Rolling Time Period
Small Caps
(% of Period Losses)
Large Caps
(% of Period Losses)
3 Months
36.8%
32.9%
6 Months
32.8%
30.2%
1 Year
27.4%
26.0%
3 Years
14.6%
15.8%
5 Years
8.9%
9.7%
10 Years
0.2%
3.9%
How Much to Allocate to
Small and Mid-Cap Stocks?
• Small and mid-cap stocks comprise about 20 percent to
25 percent of total stock market capitalization, so that is
a market-neutral exposure.
• Large-cap stocks are dangerously correlated with each
other (ETFs may be the cause).
• Some financial planners recommend that well-diversified
equity portfolios have an overweight allocation to small
and mid-caps (e.g., between 30 percent and 40 percent).
Small-Cap Stocks Increases Safe
Withdrawal Rate (SWF) in IRAs
• SWF Definition:
– “A percentage that can be applied to the value of one's portfolio
on the day before retirement to calculate the annual amount,
increased by an annual inflation factor, that can theoretically be
withdrawn from the portfolio without depleting the portfolio for the
remaining duration of one's life.”
• 1994: William Bengen (financial planner) devised the
“4% rule” based on retirement portfolio consisting of 60%
large-cap stocks and 40% intermediate government
bonds. Average duration of retirement savings before
money ran out = 30 years, which is sufficient given most
people’s lifespan.
Small-Cap Stocks Increases Safe
Withdrawal Rate (SWF) in IRAs (Page 2)
• Bengen’s follow-up study:
– Adding a 34% equity allocation to small-cap stocks
(18% small-cap, 35% large-cap, 47% bonds)
increased SWF from 4.0% to 4.5%.
• Since 1926, there have been 57 investment periods of 30 years with
January start dates from 1926 to 1983. Only one start date (Jan.
1969) did not see 4.5% SWF portfolio survive until 30th year (4.32%
would have survived). Reason? – 7.8% annual inflation between
1969 and 1980 caused withdrawal rate to increase to 12.5% after
first 12 years (1980).
• Much worse result if no small-cap allocation to neutralize
inflation! (4.04% max SWF to survive).
Small-Cap Stocks Increases Safe
Withdrawal Rate (SWF) in IRAs (Page 3)
• 2014 study by Joe Tomlinson (Maine financial planner):
– Isolating small-cap value stocks instead of using all
small-cap stocks results in optimal retirement portfolio
of 60% small-cap value and 40% government bonds
(0% large-cap stocks).
• “There is something special about small-cap value.
Based on the historical evidence, there is no
justification for holding small-cap value equity
allocations below 30%.”
Democratic President
Is Good for Small Caps!
1927-2013 Annualized Return:
Small Caps vs. Large Caps
Party in the White
House
Large Cap
Small Cap
Small-Cap
Outperformance
Democrat
Republican
13.1%
5.0%
17.8%
2.4%
4.7%
-2.6%
Democrat
Outperformance
8.1%
15.4%
Inflation is Good for Small Caps
1974-1981
(9.3% annualized inflation)
Annualized Return
Small Cap Stocks
27.1%
Real Estate
12.1%
Foreign Stocks
9.7%
Large Cap Stocks
8.0%
Commodities
6.8%
Higher Interest Rates and Stronger Economic
Growth Are Good for Small Caps
Average 12-Month Stock Performance
Equity
Style
Falling
Long
Term
Rates
Rising
Long
Term
Rates
Falling
Short
Term
Rates
Rising
Short
Term
Rates
Weak
Growth
Strong
Growth
Large Cap
12.09%
13.38%
11.37%
14.40%
7.50%
18.33%
Small Cap
11.50%
13.94%
10.40%
15.49%
5.25%
20.52%
Small
Large
Small
Large
Small
Advantage Large
Small-Cap Stocks Have Further to Run
Despite Short-Term Concerns
• Concerns:
– Small-cap stocks have risen for seven consecutive quarters, the longest period
ever.
– The P/E ratio of the small-cap Russell 2000 index is now 49, which is 26% above
the 39 P/E ratio at the Internet-bubble market top in March 2000.
• I Remain Optimistic Because:
– The Internet bubble was concentrated in the large-cap stocks of the S&P 500.
Small caps were nowhere near as overvalued as large caps in 2000, so small
caps exceeding their P/E peak from 2000 doesn’t indicate to me that small caps
are primed to fall. Furthermore, the Russell 2000 index’s current P/E ratio is
skewed by a few high-fliers — nine stocks have P/E ratios over 1,000! (e.g.,
Martha Stewart Living, comScore, TriQuint Semiconductor).
– Unlike large caps which have recently experienced record operating profit
margins, small-cap operating profit margins remain below their last-cycle peak
reading from 2006, so the “E” in the small-cap PE ratio is set to explode, which
will make the small-cap PE ratio look cheaper. Small-cap stocks are more
sensitive to the macroeconomic environment.
Small-Cap Stocks Have Further to Run
Despite Short-Term Concerns (Page 2)
• I Remain Optimistic Because:
– Annualized earnings growth for small-cap stocks over the next five years is
expected to be more than two ½ percentage points higher than large-cap
earnings growth (13.7% to 11.1%), so the higher P/E valuation is justified – on a
PEG ratio basis (P/E ratio divided by forecasted earnings growth rate), small
caps are actually cheaper than large caps.
– The outperformance by small caps in January 2014 is very good news for the
remainder of 2014. Historically, whenever small caps outperform large caps in
January, they go on to outperform large caps for the entire calendar year by an
average of more than 7 percentage points.
– Even after small caps’ strong relative performance over the past 10 and 15
years, small-cap stocks have underperformed large-caps on a buy-and-hold
basis since 1983 – by an annualized differential of 0.3 percentage points (8.1%
to 8.4%). That’s 31 years! Since over the very long term small caps have
outperformed large caps by an annualized 2.4 percentage points, small caps’
relative performance should “revert to the mean” and outperform large caps over
the next 30-year period.
Small-Cap Stocks Have Further to Run
Despite Short-Term Concerns (Page 3)
I Remain Optimistic Because:
• Sam Stovall, chief equity strategist at S&P Capital IQ, recently
wrote:
– 60 percent of bull markets that make it to their fifth year birthday (like this one did
on March 9, 2014) end up celebrating a sixth-year birthday (March 9, 2015).
– 26 percent average price increase for the S&P 500 in the sixth-year of bull
market.
– Since 1947, the average total return for small-cap stocks has usually exceeded
that of large-cap stocks in five of six bull market years. Only in year five did they
traditionally underperform.
– Since WWII, only three bull markets completed year six, and small-cap stocks
outpaced large ones in two of the three (67% of the time).
then history says, but does not guarantee, that small caps could see a late-stage
surge and outpace large caps once again.”
“Value and Momentum Everywhere”
•
Study in June 2013 Edition of The Journal of Finance. Authors: Clifford Asness of AQR
Management and Tobias Moskowitz of University of Chicago Business School
•
“Studying value and momentum jointly is more powerful than examining each in isolation. The
negative correlation between value and momentum strategies and their high positive expected
returns implies that a simple combination of the two is much closer to the efficient frontier than
either strategy alone, and exhibits less variation across markets and over time.”
•
“In every market, the value/momentum combination outperforms either value or momentum by
itself.”
•
“There is a significant return premium for value in every stock market, with the strongest
performance in Japan. Momentum premia are also positive in every market, especially in Europe,
but are statistically insignificant in Japan. The correlation between value and momentum returns is
strongly negative, averaging about –0.60. Combining two positive return strategies with such
strong negative correlation to each other increases Sharpe ratios significantly.”
–
•
Increasing liquidity risk (TED spread) is positive for value and negative for momentum (flight to safety). But
50-50 combo is impervious to liquidity risk.
“Between 1992-2011 and 1972-1991, the correlation between value and momentum has declined
from –0.44 to –0.63, and, as a result, the Sharpe ratio of the combination of value and momentum
has not changed much over time, since the increased correlation across markets is being offset by
the more negative correlation between value and momentum.
Value and Momentum is the Holy
Grail
– Value (low price to book value)
• Rebalanced Annually
– Momentum (2-month to 12-month price appreciation)
• Rebalanced Monthly
1971-2013 Period
Value Stock Portfolio
Momentum Stock Portfolio
50-50 Combination Portfolio
Cumulative Return
55 Times Original Investment
90% More Than Value
100% More Than Momentum
380% More Than Value
Value and Momentum Sharpe
Ratios (Risk Adjusted Returns)
Sharpe ratio = Excess return [R(x) – R(rf)]
divided by standard deviation of R(x)
1971-2013 Period
Sharpe Ratio
S&P 500
0.40
Value Stock Portfolio
0.73
Momentum Stock Portfolio
0.81
50-50 Combination Portfolio
1.42
(75% higher than momentum alone)
Quality Matters
– 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.
– Less than half of small-cap stocks outperform (44%), so rigorous
analysis is needed to separate the winners from the losers.
High Quality
Annualized Return
Low Quality
Annualized Return
Value Stocks
7.0%
1.6%
Momentum Stocks
5.6
0.9
1963-2013 Period
My 6-Point Safety Rating System
(i.e. Quality)
1) Piotroski F-Score of 6 or above
2) Beneish M-Score of -2.00 or more negative
3) Altman Z-Score of 3.0 or above (adjusted from last year’s 3.5)
4) Short Interest to Float Ratio of less than 10%
5) 10 Percent Insider Ownership or Recent Insider Buying
6) Beta of Less than 1.15 (adjusted from last year’s 1.0)
Best Definition of Price Momentum
•
Asness uses performance between 12 months ago and 2 months ago,
skipping latest month because of “one month reversal” phenomenon.
• 2011 study by University of Rochester professor Robert NovyMarx concludes:
– Intermediate-term performance between 12 months ago and 7 months
ago is what matters
– Short-term performance between 6 months ago and 2 months ago is
non-predictive.
• 2013 study by Swiss researcher Amit Goyal concludes:
– Novy-Marx conclusion that short-term price performance non-predictive
is wrong because of contamination by 2-month reversal effect (spillover
from 1-month reversal effect). If you take out 2nd month performance,
then 6-month to 3-month performance is predictive.
– My Conclusion: Use 12-month to 3-month performance (10 months).
Penalizing 1-month and 2-month performance also makes sense.
Relative Performance of Roadrunner
Portfolios
• Value Portfolio: 29.92 Percent (average return per stock)
• Momentum Portfolio: 0.53 Percent
• Momentum Portfolio is Not Working!
– Fault lies with me, not the momentum strategy.
– Strategy requires monthly selling of underperformers, which I did
not do in my quest to reach 20-stock portfolio size.
• Solutions:
– Now that portfolio has reached its maximum 20-stock size,
monthly selling of laggards will occur.
– Mimicking of Value Portfolio’s industry-sector diversification and
correlation analysis will end. Not relevant to momentum.
– Price performance will be only stock-selection criteria, with
tiebreakers based on safety rating system.
Relative Performance of Roadrunner
Portfolios
• Value Portfolio: 29.92 Percent (average return per stock)
• Momentum Portfolio: 0.53 Percent
• Momentum Portfolio is Not Working!
– Fault lies with me, not the momentum strategy.
– Strategy requires monthly selling of underperformers, which I did
not do in my quest to reach 20-stock portfolio size.
• Solutions:
– Now that portfolio has reached its maximum 20-stock size,
monthly selling of laggards will occur.
– Mimicking of Value Portfolio’s industry-sector diversification,
correlation analysis, valuation, and management quality, will
end. Simply not relevant to momentum.
– Price performance will be only stock-selection criteria, with
tiebreakers based on safety rating system.
Relative Performance of Roadrunner
Portfolios (Page 2)
• Examples of current Momentum portfolio holdings that
no longer qualify:
–
–
–
–
–
CommVault Systems (CVLT)
LeapFrog Enterprises (LF)
WisdomTree Investments (WETF)
HMS Holdings (HMSY)
Ocwen Financial (OCN)
• Sort Momentum portfolio by column entitled “Price to 52week High” in ascending order for most likely portfolio
deletions.
New Momentum Price-Performance
Criterion
• Maximize Formula:
– 12-month to 3-month price performance (must be at least 95th
percentile)
Minus
– 2-month price performance (minus a negative is a positive)
Minus
– 3* 1-month price performance
Five Momentum Candidates: No. 1
SunEdison (NYSE: SUNE)-- $5.1 billion
• Company formerly known as MEMC Electronic Materials.
• Developer of solar power plants for businesses and utilities. Plans to
keep best new solar projects for itself rather than sell them.
• Will soon be solar “pure play” as it plans to spin-off its silicon wafer
semiconductor business in a $250 million IPO later in 2014.
• Leader in FBR polysilicon and CCZ crystal technology.
• Strong growth in megawatt installations at a compounded annual
growth rate of more than 90% since 2009. Earnings are projected to
growth at least 15% annually over the next five years.
• Hedge fund manager David Einhorn is buying the stock and has a
$35 price target.
• Momentum Formula: 254.6
Five Momentum Candidates: No. 2
AerCap Holdings N.V. (NYSE: AER)-- $4.5 billion
•
•
•
•
Aircraft leasing company (Netherlands)
92 customers in 50 countries
$15 billion in assets and 378 modern and fuel-efficient aircraft.
“Transformative” acquisition of AIG’s aircraft leasing division –
International Lease Finance Corp. (ILFC).
– $6 billion discount to independent fair value assessment (i.e., $5 billion cost is
half price).
– Order slot for new aircraft (Airbus 350, Boeing 787) near front of the line (early
delivery, cheaper purchase prices).
– Will triple fleet to 1,400 aircraft and make company second-largest in the world
(GE is first).
• Momentum Formula: 199.3
Five Momentum Candidates: No. 3
Caesarstone Sdot-Yam (Nasdaq: CSTE) -- $1.9 billion
• Israeli manufacturer of engineered quartz stone surfaces like
kitchen countertops (cheaper than granite)
• Major housing markets: Australia, Canada, U.S.
• February 2012 IPO on Nasdaq
• Partnership with IKEA USA to be exclusive supplier of non-laminate
countertops in U.S. market.
• Momentum Formula: 170.1
Five Momentum Candidates: No. 4
Arkansas Best (Nasdaq: ABFS) -- $991 million
• Top-five “less than truckload” freight carrier in the U.S.
• 68% of the nation’s freight tonnage is carried by trucks.
• The deregulation of the trucking industry in 1980 has generated
tremendous productivity and efficiency gains.
• 2012 acquisition of Panther Expedited provides growth opportunity
in asset-light logistics services.
• Industry research firm FTR is “optimistic” about trucking in 2014 and
its Trucking Conditions Index in February – weather adjusted –
reflects the tightest truck market on record. FTR is warning shippers
that any modest uptick rise in industrial activity could act as a
“tipping point” to cause truck freight rates to skyrocket.
• Momentum Formula: 153.6 Percent
Five Momentum Candidates: No. 5
comScore (Nasdaq: SCOR) -- $984 million
• “Big data” company in Washington D.C.
• Customers include five of the top six cable companies, seven of the
top 10 credit card issuers, and five of the top six consumer banks in
the world.
• Evaluates over 1.5 trillion online user interactions each month
spanning 172 countries.
• Markets data via its Media Matrix subscription-based product mix for
use in advertising, customer service, product development, and
inventory management.
• Revenue has grown at an average annual compounded rate of 10
percent over the past three years and there’s every indication that
this pace will continue in 2014.
• Momentum Formula: 150.5
Jim Fink
Chief Investment Strategist,
Roadrunner Stocks
www.RoadrunnerStocks.com
Options for Income
www.JimFinksOptions.com