04/28/2017

Think Big! Tread Carefully In Small Caps

AFG’s process of valuing securities and grading the investment attractiveness of companies has proven to consistently work well in the small cap space (Russell 2000) at uncovering investment ideas that outperform benchmarks. This can be evidenced by the performance of our Investment Grade metrics from a purely quantitative perspective, as model portfolio results show that nearly every factor that goes in to the overall Investment Grade of a company has performed as designed (A and B Graded companies outperformed the benchmark, D and F Graded companies underperformed the benchmark) over the past 1, 3 and 5-year time periods. The chart below highlights the performance of the overall AFG Investment Grade within the Russell 2000 over the last 10 years and the same monotonic relationship from A to F is clear and a significant spread is achieved between A and F graded firms.

small-cap-r2000-ig-perf-10-yr

Our analysts also put these metrics to work in the small-cap space in the form of a model portfolio we provide to clients called the AFG 100. The AFG 100 is a sector neutral list of 100 names designed to outperform the Russell 2000. Since its inception, it has outpaced the Russell 2000 index an impressive 8 out of 10 years.

AFG’s research is best used while analyzing individual equities but from time to time we see trends in data that allow us to caution investors.  The best aggregate of data to assess the market are valuation levels and expectations analysis.  In March 2014 we noticed that the expectations for sales growth that were baked in to the median Russell 2000 company and the median valuation levels were trading at a premium. This lead us to notify our readers and recommend reducing exposure to small cap stocks or avoiding them altogether. When the levels returned to normal valuation ranges in March of 2016, we notified our readers that the small cap space was once again relatively attractive and that we would recommend normal exposure to small cap stocks. During this time the Russell 2000 delivered -7.7% relative to 8.6% returns from the Russell 1000 Large Cap Index. Since March 2016, when valuation levels returned to within normal range and we recommended normal exposure to small caps along with 20 small-cap companies as investment ideas, our list of ideas has returned about 15% slightly outpacing the Russell 2000.

After the most recent update of our aggregated Sales Growth Expectations data (as of 11-30-16) we see that the overall expectations and valuation levels have returned to the outer boundary (+1.5 Std Dev) are beginning to look expensive again. While previously this would have triggered us to potentially reduce exposure to small caps, we often find that valuations are rich for a valid reason. One major thing to keep in mind that could continue to drive these small cap companies even higher is the new President-elects proposed changes in corporate tax levels. We believe in an environment of lower tax hurdles, the most profitable small companies could be the biggest benefactors of the proposed tax changes. With so much uncertainty it makes it difficult to recommend reducing exposure to small caps at this time, but the overall valuation level of the Russell 2000 does look expensive.

r2000-expectations-chart

We believe that picking stocks utilizing AFG’s research and investment tools in the small cap space where there is much less information and analyst coverage on lower profile companies puts investors in an advantageous position to outperform. Less analyst coverage leads to more mis-priced equities and in turn leads to more opportunities to take advantage of mis-pricings. This is what we consider happy hunting grounds for stock pickers equipped with a proven process and the right research tools.

Since our track record has been solid in this space, we have decided to provide another list of attractive small-cap equities for those looking to add small-cap positions. This time however, we will provide 10 Sell Ideas along with 10 Buy Ideas since the index is beginning to look overvalued once again. These companies on the Buy List all earn an Investment Grade of A and have attractive valuations, while the Sell companies earn an Investment Grade of F and currently look expensive. By using AFG’s Investment Grade, back-tests show that a strategy of buying A & B graded companies while avoiding D & F grade companies’ investors can put themselves in a better starting point to outperform.

Russell 2000 – Investment Ideas

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