“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can” – Mark Twain
The goal for our Small-Cap Stars model was to reveal high quality stocks with a strong future in the 50m to 1B market cap range. The methodology we developed uses fundamental analysis to indicate which stocks have the greatest probability for future success based on past performance, highlighting those criteria in each sector that had the strongest statistical correlation to success for small-cap companies in the past.
Our initial attempts at finding correlations over time periods in the market as a whole proved fruitless as what makes for a strong small-cap company in each of the different sectors was unique to that sector. So the decision was made to create individual models for each of the seven main sectors: basic materials, industrial goods, technology, services, consumer goods, financial, and healthcare.
There were initially more than 50 factors inputted, and, using statistical software, we determined which were significant and which failed to show a strong correlation to future performance.
The model, when completed, produced a final regression output that gave individual significance of each variable based on the probability that that stock would ultimately prove successful and an overall probability of success when considering all the most significant variable at once.
Our Small-Cap Stars
Stocks were then selected from 2013 with a market cap being between $50 million and $1 billion. Stocks lacking the necessary data were immediately eliminated as we couldn't run our screen. The remaining companies were then ran through the model. Those companies with above-average scores were taken, while those that were below-average were discarded.
The stocks selected all fit what the model considered to be “strong candidates,” but the rankings were then determined using a different methodology. The five most important factors (which we'll outline below) were isolated for each sector, and we added the absolute value of their coefficients together. Each coefficient was then divided by the total to gather the “weights” of each.
Each stock was then compared against the five categories we determined to be important for that particular sector. The result is a percentage between 50 and 100 that illustrates how many factors the stock has that were deemed to be important by the model. Above 90 percent is a five-star stock, 50-60 percent represents a one-star stock.
- EV/EBIT: This ratio is used to decide whether a stock share is cheap relative to its peers. Rather than using just the firm's share price – which ignores debt – it uses enterprise value. That's the combined value of debt (less cash balances) and equity funds in the business. This EV is then compared to earnings before, rather than after, tax and interest – two costs that are not directly related to the operating profitability of a firm. Since the stock is considered to be overvalued when EV/EBIT is too high, a negative relationship exists when this value being above industry average.
- EV/Invested Capital: This ratio, which has an equity analog in the price to book ratio, is determined most critically by the return on invested capital earned by the firm. High return on invested capital will lead to high EV/Capital ratios, something important to tech firms.
- Reinvestment Rate: This metric measures how much of the company's earnings are invested back into the business, with a high rate demonstrating a firm investing in its future.
- Pre-Tax Operating Margin: Operating margins can be compared across companies with different debt ratios and tax rates since it's prior to financial expenses and taxes. Pretax operating income is one of the best barometers for the basic health of a business because it measures both the revenue and expenses associated with the company's primary business activities. Most venture firms agree that tech companies need high margins to be successful.
- Cash as a Percentage of Revenues: By far the most important factor in the model. Cash as a percentage of revenues shows how much cash the company has in comparison to its size. Since the tech industry can be finicky, cash can mean either survival through tough times or an opportunity to invest when the right chance comes along.
- P/BV (Negative): A ratio that compares market value to book value, calculated by dividing the current closing price of the stock by the latest quarter’s book value per share. Book value is the total value of all the company’s assets shareholders would receive if the company ever liquidated. The price to book ratio is a good indicator of whether or not a company is over or undervalued, and varies greatly between industries. For example, industries that require more infrastructure capital and machinery will have lower price to book value ratios than industries like banking or consulting which do not require extensive amounts of physical infrastructure. For basic materials, an industry heavily dependent on machinery and infrastructure capital, the model showed a tendency for higher ratings for companies with lower price to book ratios.
- Invested Capital: Represents the total cash investment that shareholders and debt holders have made in the company. The most common way to calculate invested capital is to add all the total debt and lease obligations to the amount of equity in the firm and then subtract the non-operating cash and investments. Essentially, basic materials stocks tend to do better with more invested capital. Logically, this makes sense as those companies with more invested capital can afford more machinery, produce more goods, and increase returns.
- Depreciation (Negative): A decrease in an asset’s value is generally caused by unfavorable market conditions. Depreciation on capital assets used for further means of production also occurs naturally overtime due to continued use. For the basic materials sector, high and excessive depreciation tends to have a negative effect on a company's prospects as basic materials stocks with quickly depreciating assets lose book value and subsuquently net worth.
- Trailing Net Income: A tool for representing a company’s financial performance over a 12-month period. Using a full year of trailing data can help analysts determine seasonal trading patterns that may appear as a temporary boost to a company’s financial health when examining three, six, or nine months of information. High trailing net income shows a company that, consistently throughout the year, maintains solid sales and profits while simultaneously avoiding any drop-off in a particular season.
- Institutional Holdings: How much of a publicly traded company that's held by large financial institutions, pension funds, or endowments. Generally, these outside institutions purchase large volumes of shares, usually enough to exert influence over its management. These large financial institutions also account for the vast majority of trading volume on the world's stock exchanges. For basic materials, companies with large amounts of institutional holdings tend to be rated higher in our model. Generally speaking, large financial institutions weigh their investments carefully, so if they decide to buy up large shares of a basic materials company, it must be for a good reason.
- Firm Value: The market cap of a company plus the market value of its debt. This number was not standardized for a reason. The positive relationship with stock return tells us two things: the first being that companies in the sector that can grow through debt as opposed to just issuing stock are healthier, and, secondly, that companies on the larger side of the market cap limit performed better.
- Reinvestment: Similar to reinvestment rate except without being standardized for company size, this metric goes with our previous findings on firm value: companies in the upper echelon of our market cap limits showed better performance.
- Return On Invested Capital (ROIC): The ROIC is the return a company receives on the equity invested by shareholders. A value above industry averages tends to have a positive relationship with market performance.
- Capital Expenditures (Negative): This type of outlay is made by companies to maintain or increase the scope of their operations. These expenditures can include everything from repairing a roof to a new factory. Consumer goods is not an industry that requires intense capital spending, so a number above average could indicate the company is not spending their money efficiently.
- Fixed Assets/Total Assets: A Fixed Asset is a long-term, tangible asset held for business use which is not expected to be sold in the current or upcoming fiscal year, such as manufacturing equipment, real estate, and furniture. Companies with higher ratio’s of fixed assets will generally be more stable.
- Price/Book Value (P/BV) Ratio (Negative): The price to book value ratio measures the relationship between the price of a share of stock in the company and the book value per share. It's considered a measure of the stock’s value relative to its peers. For financial stocks this makes sense, overvalued financials have likely already grown to their potential. It is, again, not an industry that places a premium on high valuations.
- Value/Book Value of Capital: While the previous relationship considered the value of the stock price to BV, this relationship is mainly concerned with the value of the company’s equity and interest bearing debt. A financial institution holds a tremendous amount of both debt and equity on its balance sheets, and, if those assets are worth more in the market than on their balance sheets, they are a stronger institution.
- 3 Year Standard Deviation: A measure of volatility using the three-year mean of the stock. The positive relationship indicates that stocks with more volatility in the financial sector are more likely to gain, however this should be considered along with the other metrics.
- Fixed Assets/Total Assets (Negative): Banks do not make their money off of fixed assets, so a higher ratio would indicate a poor use of their money.
- Market Debt to Capital: Financial companies typically engage in higher leverage (more debt), but this is usually a sign of a healthier institution, oddly enough. A bank must be more solvent in order to engage in greater leverage, so the positive relationship makes sense because higher leverage means more profits.
- Enterprise Value (EV): Enterprise value is the market cap of a firm plus all marketable debt minus cash. This non-standardized metric shows us, again, that the upper echelon of the market cap outperforms the lower. Also, considering that the model supports this theory with its Book Debt to Capital ratio, it could show that a level of debt is important for industrial goods companies. A larger business also means more stability and a greater likelihood of larger, more-profitable contracts.
- Cash: Since this number is not standardized, it again shows us that the larger companies are performing better than the small ones on average. It also confirms that the debt is a more important factor in EV than cash.
- Growth in Revenue Last Year: This simply shows that an industrial goods company growing its revenue is more likely to keep growing in the future. Industrial goods firms are extremely capital intensive, and projects can take some time to begin generating profit.
- Net Margin: Net income over sales. This ratio shows how much the company can price goods to its advantage.
- Book Debt to Capital: We mentioned this ratio earlier, it is the book value of debt over the book value of capital. Companies that raise their money through debt as opposed to equity are likely to be more stable. Raising money through debt ultimately means you can get a loan from a bank, which is not an easy task these days.
- EV/EBITDA: The inclusion of EBITDA as opposed to EBIT or EBT shows that measures of interest expense, taxes, and dep/amort are all important to healthcare companies. Healthcare is an industry that places a premium on high valuations, so it makes sense that the companies with higher initial valuations would perform better.
- Value/Book Value of Capital: As opposed to financials, this works as a valuation metric of its balance sheet assets compared to its market value. A higher ratio implies higher valuation.
- FCFF (Negative): Free cash flow to the firm is the amount of cash left over after all expenses are covered. A high metric is good for many industries, but for healthcare, which is an industry that requires constant innovation, it is considered to be a sign that the company is not adequately reinvesting profits.
- Capital Expenditures: Higher capital expenditures means a company is spending more to develop and grow its business, in the healthcare industry this is extremely important.
- Intangible Assets/Total Assets: This is perhaps the least surprising positive metric for healthcare companies. Healthcare is an industry that is dependent on its patents, which are included in intangible assets, so a higher ratio would indicate that the company has a strong future.
- Firm Value: Once again, a positive correlation to size. Since we have positive relationships with debt in the model, we can also assume that it means the companies with access to debt are likely healthier.
- Pre-Tax Operating Margin: The pre-tax operating margin is the profit margin before taxes have been paid. The most-likely conclusion here is that taxes are not particularly important to service companies as most services firms have similar tax rates. The high margin is consistent with the idea that companies will perform better with extra pricing control.
- Dividends (Negative): Since most of the companies did not in fact issue dividends, this metric is more based on whether the company did or did not offer them as opposed to how much it was. Issuing dividends usually means there is a lack of other areas to spend the money, something that's usually not a good sign for a growing company. For the services industry, the money is usually better spent in advertising.
- Market Debt/Equity: This was mentioned earlier, it states that companies who are getting capital through debt are likely more healthy than companies who are getting capital through equity offerings. This makes sense as banks have more stringent requirements for loans than stockholders.
- Institutional Holdings: The amount of large financial institutions that hold the stock. The “smart money” typically goes to the stock most likely to succeed. It could mean that the stock recently became eligible for mutual fund purchase or that it is hot, but institutional investment typically indicates a strong company.