Low-priced stocks are perhaps the single most alluring and frightening segment of the equity landscape. Prices ranging from pennies to just a few dollars per share can elicit feelings of excitement or dread.
Labels like “small-cap”, “micro-cap” and “penny stocks” stir investor emotion—both good and bad. (And for the purposes of this article each label is used interchangeably.)
Take for instance the moniker of “penny stocks”. There is no doubt about their allure . …And why? Because when things go right with penny stocks they go right in a HUGE way.
But the intense emotion surrounding the potential for profits in micro-caps can also show up as substantial fear and avoidance of the asset class. And unfortunately… these fears are validated all too often.
To put it bluntly, many penny stocks lack legitimacy as a public company. And if you aren't careful you can end up investing in a corporate entity that’s fully legal but whose business model is vague and untested … at best.
And even if the company is bona fide—with a solid business model and management team—the survival risk for these smaller companies is still a valid concern. The conventions of larger more established markets provide a level playing field for bigger companies. While the prospects for small cap growth opportunities can be quickly eclipsed by the need for survival.
The financial markets can be the harshest of environments. And any tool that can aid in financial survival AND growth can be invaluable.
This is where mechanical models for small and micro cap investing can radically increase investment success. (See my prior article regarding the value of systematic models.)
Big Tools For Little Stocks
Systematic models allow us to apply proven standards of fundamental analysis. And the universe of super-low priced stocks is no different. Mechanical models can diminish the fright without necessarily compromising the potential for profits.
Fama & French put these standards to the test with their extension of the Capital Asset Pricing Model (CAPM). The Fama-French three factor model adds “small capitalization” as an integral part of the accurate pricing of assets. They see small capitalizations no different than other rudimentary factors like growth rates, balance sheets, margins, and the like.
And my goal has been to expand Fama & French into a usable small-cap model for the average investor. The model seeks to remove all the noise around small caps and get to the money making. No need to rely on hearsay, gut feelings, or seat-of-the-pants-assessments.
This small cap model provides emotionless returns—high on reward with “managed risks”. Get ready as we apply the same disciplines of large scale investing to the low-priced stock arena.
Key initial factors include but are not limited to:
- Positive earnings OR positive cash flow/share in TTM
- Market capitalization < $500 million
- Better than industry profitability
- ROE trending higher
- Positive Price Persistency
- Market-Timing rules: Macroeconomic factor model
- “Demand” for stock greater than “Supply” of stock
In my next post we will start breaking down specific stocks. After the initial screen we will implement a ranking system for growth, value, and quality. And through a disciplined “emotion-less” process we will build an enviable low-priced stock portfolio.
As always, you can get a head start on these investment models at the Portfolio Café.
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