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Phil Dabo: Welcome to Quant Concepts. Small cap stocks have done fairly well over the past year with the S&P SmallCap 600 Total Return Index up 57%, while the broader S&P 500 Total Return Index is up 42.9%. Small cap stocks are typically more cyclical, which means that they outperform during an economic expansion. The economy will continue to reopen as more and more people get vaccinated, which can potentially extend the market rally.
Today, let's take a look at a strategy that focuses on small cap stocks that are trading at a discount to sales. As always, let's start by selecting our universe of stocks which includes approximately 500 companies in the U.S. with a market cap of less than $1.8 billion. Next, we are going to rank our stocks from 1 to 500 according to five key factors.
The first factor is the price to sales to find companies that are trading at a discount. And I used sales instead of earnings because it's hard for companies that are smaller to have higher earnings, especially if they haven't been around for a very long time. Next, I used the trailing return on equity, which is a good measure of financial performance. Now, the next three factors are meant to capture companies that have recently reported stronger earnings, where analysts have a positive outlook for earnings per share and the company has been able to beat those expectations.
Now that we have our stocks ranked from 1 to 500, we are going to go through our screening process, starting with our very first buy rule, which will eliminate companies that are not in the top 30th percentile of our ranking. We are only going to buy stocks that have a return on equity above 20% and where analysts have a relatively positive outlook for in terms of earnings per share. I used the Morningstar quantitative health score to eliminate companies that are in a relatively worse financial position. Now, the last two factors have to do with price momentum. I used the price change to 12-month high because companies trading close to their previous 12-month high have tended to perform well. The last factor is a technical indicator that compares the market index to its 80-day moving average. This is a medium to short-term relative strength variable that's meant to move the strategy out of cash if we're going through an up market. I used it for this small cap strategy because I only want to capture the upside of the market.
Now, let's take a look at our sell rules, which are very simple. We are going to sell stocks if they deteriorate and fall to the bottom half of our list, and we are going to move the strategy into cash if the price drops significantly below its 80-day moving average. The last sell factor is the three-month earnings revision to eliminate companies that have the worst changes in analysts' expectations for the current year's earnings per share.
Now, let's take a look at performance. The benchmark that we used is the S&P 500 total return index, and we tested the strategy from January 2006 to October 2021. Over this time period, the strategy has generated a very strong 26% return, which is 15.3% higher than the benchmark with a very high annualized turnover of 166%. When looking at the annualized returns, we can see that this is a strategy that has outperformed the benchmark over every significant time period. However, it's done so with higher price risk as you can see by standard deviation. This is also expected when taking a look at small cap companies. That being said, the strategy still generates a very strong risk-adjusted return as you can see by the Sharpe Ratio, and it also has lower market risk as you can see by beta. This is expected with smaller cap companies in the strategy that don't move in the same way as the broader S&P 500.
When taking a look at this performance chart, we can see very good outperformance over time, especially over the past couple of years through the COVID recovery. And when looking at the up and downside capture ratios, we can see that this is a strategy that has performed well in both up and down markets, which contributes very nicely to an overall market capture ratio. And I also think that it's important to mention that this strategy has rarely had a negative calendar year over the past 15 years.
This is a great strategy to consider if you are looking to add some diversification to your portfolio with smaller companies. This strategy has performed very well since inception as I mentioned before, with only three negative calendar years. Although there are a lot of inherent risks with this strategy, including higher turnover, higher volatility and the potential for a bit of illiquidity, I think that some of the names on the buy list can still provide really good short-term return if you believe that smaller companies still have a lot more room for growth. You can find the buy list along with the transcript of this video.
From Morningstar, I'm Phil Dabo.
For the buy list, click here.
