Small Cap Value Screens That Crush the Market

I'm still working on putting together some screens and backtests of small cap value stocks. However, if you read below you may get an idea of some of the criteria I'm looking at.... :)

Before I dive into it, I encourage you to check out a new free video on the Gold market from Marketclub of which I am an affiliate. They are putting out a ton of free videos right now that do not require any registration, just click, watch and learn. If you are interested in their trading service, you can try it for 30 days risk-free if you Click Here. Also, I did an analysis on some of their historical returns on my blog here.



Here are some value and/or small cap screen ideas used by others. None of these strategies should be taken at face value, as the past performance does not guarantee any future success. Moreover, trading frictions (turnover) should be considered by anyone before following a strategy:

1)A reader was nice enough to point out the Value 40 Fund which is tracked by the University of Michigan. I haven't spent a great deal of time looking at the history, but on the surface I cannot find information on the specific criteria and rules used to comprise the fund so I am reluctant to use it. That being said, it has crushed the S&P 500 since 2004.

2) The American Association of Individual Investors (www.aaii.com) does a great job of tracking a wide variety of stock screens and includes historical returns. It costs $29 annually for a basic membership. Among the more successful value screens are ones they call 'Piotroski Price-to-Book Screen' and 'Screening for Free Cash Flow'. The performance charts of both are below:





















The most successful Growth & Value screen is the 'O'Shaughnessy Tiny Titans' screen which looks for small to microcap value stocks. It's performance has been impressive, however read below for a caveat:












CXOAG did a great job of reviewing some of the AAII screens here. The top he studied are below (a direct quote):

The following two charts depict the monthly returns during January 1998 through July 2009 for the two screening approaches with the highest average monthly returns after including approximated trading frictions. The two screens are:

1. O'Neil's CAN SLIM, with average monthly return 2.22% (2.79% without trading friction).
2. O'Shaughnessy Tiny Titans, with average monthly return 2.17% (2.59% without trading friction).

Each chart includes a best-fit linear trend line as a rough measure of the trend in monthly returns over the sample period, with trend indications as follows:

The monthly return trend line for the O'Neil CAN SLIM screen is flat, indicating steady performance. However, the performance record of this screen has one extremely influential month (June 2009). Without this one month, the average monthly return for the screen is 1.74% instead of 2.22%, and the return trend line slopes noticeably down over time.

The monthly return trend line for the O'Shaughnessy Tiny Titans screen trends noticeably down over time. The name of the screen suggests high trading frictions (bid-ask spreads). This screen has a drawdown of almost 50% during the three months September 2008 through November 2008.

A downtrending monthly return could indicate that:

• The early part of the sample period contains data mining bias (good luck) due to discovery and selection via testing of many screens on the same data set.
• Increasing use of the screen after discovery has depressed its outperformance as more and more investors/traders share its advantage. In other words, the market has adapted to the screen.
• General market conditions have otherwise changed such that what worked earlier in the sample period does not work late

In other words, just because these screens worked in the past, does not mean they will in the future. Recent performance may indicate this trend could be upon the Tiny Titans. In addition, portfolio turnover could create an additional drag on the

The CANSLIM strategy (current earnings growth, annual earnings growth, new highs, small float, relative strenght leaders, institutional sponsorship, overall market direction) referenced above is discussed by William O'Neil in his book How to Make Money in Stocks: A Winning System in Good Times and Bad, Fourth Edition

The performance chart below:











Hopefully this will give you an idea of some places you can start to do your own research. As mentioned before, I'd like to put together some screens of my own to share with everyone. Also, as a teaser, in a future post I'm going to give you a great (free) website you can use to experiment with your own screens and backtest them....

Sitka: Stocks Currently High-Risk, Low Potential Return

Sitka Pacific Capital's October letter (pdf) was just emailed to me, some interesting charts and analysis. I have included a few excerpts below:

The above overview of where we find ourselves within those long-term cycles is meant to give some context to our discussions of our short-term outlook, as well as out positioning in our portfolios. The main reason why we remain cautious is because stocks are not in a long-term bull market, and therefore we must continue to approach stocks in terms of their value as a trading opportunity. And as with any trade, you have to carefully weigh the opportunity for gains against the potential for loss....

...From our vantage point, stocks appear to be in a high-risk, low-potential-return position after the steep rally from the March low. This is why we have remained hedged over the past few months, despite the continued advance. Although there is the possibility that stocks could find renewed strength and prove us to have been too cautious, we would rather see the market offer more real evidence of underlying strength in light of the long-term and short-term risks...

...During the 2003-2007 bull market, one of the signs that it was a cyclical bull market within a long-term bear market was that although stocks rallied, they did so only nominally priced in dollars. Against gold and other real assets, they declined.

Win Your Share of $5000

One of my favorite finance sites, INO.com, is giving away $5000 in December:

INO.com invites you to enter the “Trader’s Blog Holiday Giveaway.” Enter for your chance to win one of twelve prizes, worth over $5,000.00 total to be given away.

INO will be selecting one winner every Monday, Wednesday, and Friday starting on November 30th through December 25th. The winner will select their choice of prize and the remainder of the prizes will be available for the next winner picked.

You can read about the prizes up for grab here

Good Luck and Happy Holidays,

Scott

John Hussman: Fed Unconstitutiionally Abusing Powers; Shifting Out of TIPS

John Hussman continues to depress us with his insightful analysis. Of significant note, however, is that he is shifting away from TIPS to medium term treasuries (see bottom 2 paragraphs):

The big picture is this. There is most probably a second wave of mortgage defaults in the immediate future as a result of Alt-A and Option-ARM resets. Yet our capacity to deal with these losses has already been strained by the first round that largely ended in March. The Federal Reserve has taken a massive amount of mortgage-backed securities onto a balance sheet that used to be restricted to Treasury securities. The purchase of these securities is reflected by a surge in cash reserves held by banks. Not only are the banks not lending these funds, they are contracting their loan portfolios rapidly. Ultimately, in order to unwind the Fed's position in these securities, it will have to sell them back to the public and absorb those excess reserves, so to some extent, the banking system can count on losing the deposits created by the Fed's actions, and can't make long-term loans with these funds anyway.

Increasingly, the Fed has decided to forgo the idea of repurchase agreements (which require the seller to repurchase the security at a later date), and is instead making outright purchases of the debt of government sponsored enterprises (GSEs such as Fannie Mae and Freddie Mac). Again, the Fed used to purchase only Treasuries outright, but it is purchasing agency securities with the excuse that these securities are implicitly backed by the U.S. government.

This strikes me as a huge mistake, because it effectively impairs the Fed's ability to get rid of the securities at the price it paid for them, should Congress change its approach toward the GSEs. It simultaneously complicates Congress' ability to address the problem because Bernanke has tied the integrity of our monetary base to these assets. The policy of the Fed and Treasury amounts to little more than obligating the public to defend the bondholders of mismanaged financial companies, and to absorb losses that should have been borne by irresponsible lenders. From my perspective, this is nothing short of an unconstitutional abuse of power, as the actions of the Fed (not to mention some of Geithner's actions at the Treasury) ultimately have the effect of diverting public funds to reimburse private losses, even though spending is the specifically enumerated power of the Congress alone.

Needless to say, I emphatically support recent Congressional proposals to vastly rein in the power (both statutory and newly usurped) of the Federal Reserve. Starting with the Bear Stearns deal, the Fed under Ben Bernanke has made a sharp and distinct departure from its historical role, in violation of its charter. As I noted when the bondholders of Bear Stearns were rescued, “The troubling aspect of the Fed's action was not that it lent to a non-bank entity. That ability is clearly authorized by Section 13(3) of the Federal Reserve Act. The problem is that it made its “loans” as “non-recourse” funding – meaning that it would not stand to be repaid if the collateral itself was to fail.” This is still what the Fed seems determined to accomplish.

In my view, deeper loan losses are ahead, and if we deal with the next round the same way that we dealt with the last, we will ultimately succeed in debasing the U.S. dollar. There's little inflationary pressure at present, and chances are that fresh credit concerns will create enough demand for government liabilities to forestall inflationary pressures for several years more. But we cannot reimburse the losses of irresponsible lenders with trillions freshly issued government liabilities without those liabilities ultimately eroding in value. The probable real, after inflation return on stocks and bonds over the coming decade is likely to be very unsatisfactory.

While I do expect that we will observe longer-term inflation problems beginning several years out, the problem with negative real yields on TIPS is that in the event that inflation does not present itself near-term, TIPS holders are forced to accept negative current returns as the price of longer-term inflation protection.

Generally speaking, market participants do not sit with this sort of “negative carry” trade for very long once price momentum eases. For that reason, we shifted a significant portion of assets in Strategic Total Return out of TIPS and into medium-term nominal Treasury securities last week. The overall duration of the Fund continues to be moderate, at just over 3 years. We also exited our foreign currency holdings last week on strength. The Fund continues to hold about 1% of assets in precious metals shares, and about 4% of assets in utility shares.

Hump Day Investment Articles: Gold, China, Deflation, Taxes and More

I'd like to get away from posting links to so many articles, but I've been scouring the web and my inbox of late and found some recent articles of note and worthy of passing on:

Deep reading from Eclectica's November Fund Commentary, an excerpt:

Japan has championed both Friedman and Keynes. They have built bridges to nowhere and dropped Yen notes from helicopters for twenty years and still they have nothing to show for it. Clearly the additional return from Yen debt in Japan is close to zero and it exposes the nightmare of interventionists everywhere: it may just be that there are no policy remedies for a debt deflation. So to elaborate further, our chances of financial success are greatest under conditions where investors believe government spending will succeed but in reality it fails.

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Via The Big Picture, David Rosenberg asks the question: Is Gold a bubble? The historical gold/spx ratiochart puts it in perspective:

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Jim Jubak: Let China Put Money in Your Pocket

Here are five ways that you could make the current dollar-renminbi peg your friend and put the future appreciation of the Chinese currency to work for you:

• You could buy an actively managed mutual fund. I personally own shares in Matthews China (MCHFX). Matthews funds have a long history of kicking the tires in Asia, and there's good value to an investor in paying the 1.23% expense ratio to get that expertise. Here's the company's Web site.
• You could buy an ETF. I'd suggest the iShares FTSE/Xinhua China 25. With one buy, you get exposure to the big boys of China's economy, including China Mobile (CHL, news, msgs), China Life (LFC, news,msgs) and PetroChina (PTR, news, msgs).
• You could buy a big hunk of the growing market for consumer financial products by buying shares of China Life. The company has about 50% of the still-very-young insurance market in China. But as China gets wealthier and older -- by 2050, a higher percentage of China's population will be 60 or older than the United States' -- more people will look to consumer financial products such as life insurance to provide for old age and to provide security to the next generation.
• You could buy into the continued emergence of a consumer economy in China by buying shares of Ctrip.com (CTRP, news, msgs), the largest online travel company in China. On Nov. 11, the company reported an 80% increase in third-quarter profits on a 41% jump in hotel reservations and a 45% gain in flight bookings.
• And you could buy into China's huge need for water and water infrastructure by buying shares of Duoyuan Global Water (DGW,news, msgs), a supplier of water treatment equipment. On Nov. 9, the company reported that third-quarter revenue had climbed 31% from the third quarter of 2008, gross margins had climbed to 49.5% from 46.8% and operating income was up 31.1%. The company divides its business into three product lines: wastewater treatment equipment, circulating water treatment and water purification equipment.

You probably have other China stocks that you like. Just remember that to get the biggest bang out of the eventual end of the dollar-renminbi peg, you should look for Chinese companies that do the bulk of their business inside China in renminbi.

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Want to know who pays income taxes in the US? Good chart from mint.com, courtesy of The Big Picture again.

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Donald Coxes gives portfolio/investment insights for November (courtesy of Investment Postcards):

The November edition of Donald Coxe’s Basic Points research report (subtitled “The Power of Zero”) has just been published. His investment recommendations, as summarized in this document, are listed in the paragraphs below, but I do recommend you also read the full report at the bottom of the post. (Also note that Donald’s weekly webcasts can be accessed from the sidebar of the Investment Postcards site.)

1. Remain underweighted in US equities-as a percentage of total equities within global portfolios, and as a percentage of assets in US balanced portfolios. Underweight US bonds in global portfolios.

The Obama long-term financial projections for the US are high risk and unsustainable. Forthcoming elections-or a currency crisis-could induce some discipline, but within the OECD, the US should probably no longer be accorded top ranking for bonds and stocks.

2. Within the US market, underweight US economy-related stocks and overweight stocks tied to global economic activity.

Watch the performance of the KRE compared to both the BKX and S&P. As long as the KRE underperforms both of these indices, US-economy-related stocks remain suspect.

3. Overweight Emerged Markets (such as China, Brazil, India, and Korea) within global and international equity portfolios.

These markets should no longer be routinely discounted heavily for political risk or accounting practices relative to the US. The credibility gap has narrowed in the past year.

China continues to report robust economic activity and skeptics continue to proclaim-as they have for years-that it’s unsustainable. The time to sell China, and, for that matter, base metal and energy stocks, is when the last remaining Sino-skeptic has become unemployed.

4. Overweight the precious metal miners relative to bullion or the ETFs.

The time to overweight the ETF is when precious metal prices have entered corrections.

The XAU and other gold stock indices have underperformed bullion for the past two months because of a succession of bad news announcements for such heavyweights as Barrick, Kinross and Agnico-Eagle. True, we can’t be sure there won’t be more reports of disappointing execution among the miners, but they have the reserves in the ground, and the best of them have “unhedged reserves in politically-secure areas of the world”. Investors who believe current prices could hold should do NAV calculations on the miners based on current gold and silver prices, and they will see excellent opportunities in the stocks.

5. Overweight the leading agricultural stocks. The farm equipment, seed and fertilizer stocks are core investments for the next cycle.

With one of the coldest and wettest Octobers on record, Midwest farmers’ crops at October-end were overdrenched, overdue and overrun with blights and moulds. Recent warmer and dryer weather has improved yields, and the heaters are working overtime to dry out what has been harvested-and corn and soybean prices have pulled back slightly from their recent highs.

Global carryovers will not increase this year, which means world food “surpluses” remain precarious-as evidenced by the sharp run-up in rice.

6. The base metals stocks have been the global commodity stars. The best stock market values now could be in the small-caps that are long on ore and short-or nil-in earnings.

In retrospect, we should have recommended overweighting in this sector, but we were spooked by the collapse of the Baltic Dry Index and its subsequent failure to rally-and the relatively high levels of inventory on the LME. It appears that China has used some of its surplus dollars to get China overstocked on metals.

7. Overweight Canadian oil sands stocks within equity portfolios.

The Canadian oil sands stocks continue to suffer bad press among the defenders of the planet about alleged environmental misdeeds and risks. Each dead duck listed in shocked reports sent across the world has been worth millions in reduced market cap for the companies. (The actual total number killed in this supposed replay of the Exxon Valdes is what a few hunting parties would collectively bag on a good weekend.) A major Canadian institution recently joined this parade of the super-chic by publishing a supposedly unbiased study on oilsands emissions that was prepared by two of that nation’s pre-eminent greenhouse gasbags. The institution could have achieved the same results by retaining Gore-but Gore costs more. Treat those fashionable emissions with caution-and treat your portfolio to oil sands stocks.

8. Overweight Canada in both equity and fi xed income portfolios, and remain long the loon against the greenback.

In recent global rankings, Canada ranked #1 in the G-7 for its central bank, its private banks, and its Minister of Finance (who is the longest-serving in the G-7-a remarkable feat for a minister in a minority government). The principal knock on Canada is that it is dull. Dull has become the new shiny.

9. In balanced portfolios with an equity bias, do not hold high Cash exposures. Hold long-duration, high-quality bonds.

If this rebound becomes a sustained boom, you will lose-rather modestly-on this exposure, but your equity holdings will appreciate substantially, and you will be a net winner. If it becomes a bust, you will win on the bonds, thereby reducing your overall portfolio loss. Long bonds nowreduce short-term cyclical risk. As of October, speculators were hugely short 30-year and 10-year Treasurys and hugely long 2-year Notes-consistent with a bullish call on stocks and the economy. If that call swings to bearish, there will be a rush to the long end.

Trading Ideas from Jim Welsh

Good stuff from Jim Welsh, courtesy of The Big Picture. Welsh seems to have solid analysis on a regular basis. Here is a recent trading strategy idea he wrote on the 13th. Since the S&P 500 has reached his target, I'm assuming he is now short and has been short gold since early last week (which seems like a dangerous trade to me). As always, please do your own due diligence:

In mid October, the overall health of the market was in good shape. That isn’t the case now, as the internal strength of the market has clearly weakened, especially when compared to the increase in the DJIA, which only measures 30 stocks. This means the market is vulnerable to the largest decline since the March lows, and will likely fall below the recent low of 1029.38 on the S&P. Selling into strength and taking a more defensive posture is more warranted now than in mid October.

Since the Russell is the weak sister, shorting the Russell 2000 by buying TWM makes the most sense. Establish a 50% short position now (TWM under $29.35), and add if the S&P climbs above 1105.37. The short term price pattern on the S&P and DJIA suggest that there could be one more move above the intra day highs established on November 11(DJIA 10,341.97, S&P 1,105.37). For those who prefer the S&P, go 50% short above 1,105.37, and add if the S&P reaches 1,115.00

Gold and Gold Stocks

In a Special Update on gold and the gold stocks on November 5, 2009, I laid out the following analysis and trading strategy. “I would be surprised if gold doesn’t push above $1,100, at least temporarily. However, gold should not close above $1,115, so that will act as the stop for the following strategy, which is going to break the exposure into thirds.”

DZZ – Buy 33% now ($15.20), 33% below $14.95, and 33% if it trades down to $14.65 – $14.35.
GLD – Short 33% now ($106.82), 33% above $107.50, and 33% if it trades up to $108.50 to $110.50.

On November 11, December gold closed at $1,114.60. If I’m right about stocks having one more push to a higher high on the DJIA and S&P, gold will likely make a higher high. For now, cancel the stop at $1,115.00.