Find the Next Apple Using Momentum: 5 Hidden Gems

Promising Sensational Small-Cap Success

The Wealth Summit

May 2014

Jim Fink

Small-Cap Value Outperforms“Big companies have small moves, small companies have big moves.”

-- Peter Lynch, Fidelity Magellan

Over an 86-year period, a 5.2 percent annualized enhancement (15.1 percent vs. 9.9 percent) resulted in a portfolio size that was 53 times larger.

Equity Style Compound Annual Return (1927-2013)

$1 Invested in 1927 Worth in 2013

Small-Cap Value 

15.1% $178,845

All Small Cap 12.1% $18,454

Large-Cap Value 12.0% $17,090

All Large-Cap 9.9% $3,356

Long-Term Gov’t Bonds 5.5% $100

What is a Small-Cap Stock?

• Small-cap: Between $250 million and $3 billion • Mid-cap: Between $3 billion and $10 billion • Large-cap: Above $10 billion

– S&P 500: Average Market Cap of $28.2 billion. Weighted average market capitalization is $106.5 billion.

Recent Relative Annualized Returns(as of 12/31/2013)

Time Period Small Caps Mid Caps Large Caps

1 Year 

38.8% 34.8% 33.1%

3 Years 15.7% 15.9% 16.3%

5 Years 20.1% 22.4% 18.6%

10 Years 9.1% 10.2% 7.8%

15 Years 8.4% 9.2% 5.1%

Small Caps Safer Than Large Caps Over Longer Time Frames(12/31/1939–12/31/2013)

Rolling Time Period Small Caps(% of Period Losses)

Large Caps(% of Period Losses)

3 Months 

36.8% 32.9%

6 Months 32.8% 30.2%

1 Year 27.4% 26.0%

3 Years 14.6% 15.8%

5 Years 8.9% 9.7%

10 Years 0.2% 3.9%

How Much to Allocate to Small and Mid-Cap Stocks?

• Small and mid-cap stocks comprise about 20 percent to 25 percent of total stock market capitalization, so that is a market-neutral exposure.

• Large-cap stocks are dangerously correlated with each other (ETFs may be the cause).

• Some financial planners recommend that well-diversified equity portfolios have an overweight allocation to small and mid-caps (e.g., between 30 percent and 40 percent).

Small-Cap Stocks Increases Safe Withdrawal Rate (SWF) in IRAs

• SWF Definition: – “A percentage that can be applied to the value of one's portfolio

on the day before retirement to calculate the annual amount, increased by an annual inflation factor, that can theoretically be withdrawn from the portfolio without depleting the portfolio for the remaining duration of one's life.”

• 1994: William Bengen (financial planner) devised the “4% rule” based on retirement portfolio consisting of 60% large-cap stocks and 40% intermediate government bonds. Average duration of retirement savings before money ran out = 30 years, which is sufficient given most people’s lifespan.

Small-Cap Stocks Increases Safe Withdrawal Rate (SWF) in IRAs (Page 2)

• Bengen’s follow-up study: – Adding a 34% equity allocation to small-cap stocks

(18% small-cap, 35% large-cap, 47% bonds) increased SWF from 4.0% to 4.5%.

• Since 1926, there have been 57 investment periods of 30 years with January start dates from 1926 to 1983. Only one start date (Jan. 1969) did not see 4.5% SWF portfolio survive until 30th year (4.32% would have survived). Reason? – 7.8% annual inflation between 1969 and 1980 caused withdrawal rate to increase to 12.5% after first 12 years (1980).

• Much worse result if no small-cap allocation to neutralize inflation! (4.04% max SWF to survive).

Small-Cap Stocks Increases Safe Withdrawal Rate (SWF) in IRAs (Page 3)

• 2014 study by Joe Tomlinson (Maine financial planner): – Isolating small-cap value stocks instead of using all

small-cap stocks results in optimal retirement portfolio of 60% small-cap value and 40% government bonds (0% large-cap stocks).

• “There is something special about small-cap value. Based on the historical evidence, there is no justification for holding small-cap value equity allocations below 30%.”

Democratic President Is Good for Small Caps!

Party in the White House

Large Cap Small CapSmall-Cap

Outperformance

Democrat 13.1% 17.8% 4.7%Republican 5.0% 2.4% -2.6%

Democrat Outperformance

8.1% 15.4%  

1927-2013 Annualized Return: Small Caps vs. Large Caps

Inflation is Good for Small Caps

1974-1981 (9.3% annualized inflation)

Annualized Return

Small Cap Stocks 27.1%

Real Estate 12.1%

Foreign Stocks 9.7%

Large Cap Stocks 8.0%

Commodities 6.8%

Higher Interest Rates and Stronger Economic Growth Are Good for Small Caps

Average 12-Month Stock Performance

EquityStyle

Falling Long Term Rates

Rising Long Term Rates

Falling Short Term Rates

Rising Short Term Rates

Weak Growth

Strong Growth

Large Cap 12.09% 13.38% 11.37% 14.40% 7.50% 18.33%

Small Cap 11.50% 13.94% 10.40% 15.49% 5.25% 20.52%

Advantage Large Small Large Small Large Small

Small-Cap Stocks Have Further to Run Despite Short-Term Concerns

• Concerns:– Small-cap stocks have risen for seven consecutive quarters, the longest period

ever.– The P/E ratio of the small-cap Russell 2000 index is now 49, which is 26% above

the 39 P/E ratio at the Internet-bubble market top in March 2000.

• I Remain Optimistic Because:– The Internet bubble was concentrated in the large-cap stocks of the S&P 500.

Small caps were nowhere near as overvalued as large caps in 2000, so small caps exceeding their P/E peak from 2000 doesn’t indicate to me that small caps are primed to fall. Furthermore, the Russell 2000 index’s current P/E ratio is skewed by a few high-fliers — nine stocks have P/E ratios over 1,000! (e.g., Martha Stewart Living, comScore, TriQuint Semiconductor).

– Unlike large caps which have recently experienced record operating profit margins, small-cap operating profit margins remain below their last-cycle peak reading from 2006, so the “E” in the small-cap PE ratio is set to explode, which will make the small-cap PE ratio look cheaper. Small-cap stocks are more sensitive to the macroeconomic environment.

Small-Cap Stocks Have Further to Run Despite Short-Term Concerns (Page 2)

• I Remain Optimistic Because:– Annualized earnings growth for small-cap stocks over the next five years is

expected to be more than two ½ percentage points higher than large-cap earnings growth (13.7% to 11.1%), so the higher P/E valuation is justified – on a PEG ratio basis (P/E ratio divided by forecasted earnings growth rate), small caps are actually cheaper than large caps.  

– The outperformance by small caps in January 2014 is very good news for the remainder of 2014. Historically, whenever small caps outperform large caps in January, they go on to outperform large caps for the entire calendar year by an average of more than 7 percentage points.

– Even after small caps’ strong relative performance over the past 10 and 15 years, small-cap stocks have underperformed large-caps on a buy-and-hold basis since 1983 – by an annualized differential of 0.3 percentage points (8.1% to 8.4%). That’s 31 years! Since over the very long term small caps have outperformed large caps by an annualized 2.4 percentage points, small caps’ relative performance should “revert to the mean” and outperform large caps over the next 30-year period.

Small-Cap Stocks Have Further to Run Despite Short-Term Concerns (Page 3)

I Remain Optimistic Because:

• Sam Stovall, chief equity strategist at S&P Capital IQ, recently wrote:

– 60 percent of bull markets that make it to their fifth year birthday (like this one did on March 9, 2014) end up celebrating a sixth-year birthday (March 9, 2015).

– 26 percent average price increase for the S&P 500 in the sixth-year of bull market.– Since 1947, the average total return for small-cap stocks has usually exceeded

that of large-cap stocks in five of six bull market years. Only in year five did they traditionally underperform.

– Since WWII, only three bull markets completed year six, and small-cap stocks outpaced large ones in two of the three (67% of the time).

then history says, but does not guarantee, that small caps could see a late-stage surge and outpace large caps once again.”

“Value and Momentum Everywhere”• Study in June 2013 Edition of The Journal of Finance. Authors: Clifford Asness of AQR

Management and Tobias Moskowitz of University of Chicago Business School

• “Studying value and momentum jointly is more powerful than examining each in isolation. The negative correlation between value and momentum strategies and their high positive expected returns implies that a simple combination of the two is much closer to the efficient frontier than either strategy alone, and exhibits less variation across markets and over time.”

• “In every market, the value/momentum combination outperforms either value or momentum by itself.”

• “There is a significant return premium for value in every stock market, with the strongest performance in Japan. Momentum premia are also positive in every market, especially in Europe, but are statistically insignificant in Japan. The correlation between value and momentum returns is strongly negative, averaging about –0.60. Combining two positive return strategies with such strong negative correlation to each other increases Sharpe ratios significantly.”

– Increasing liquidity risk (TED spread) is positive for value and negative for momentum (flight to safety). But 50-50 combo is impervious to liquidity risk.

• “Between 1992-2011 and 1972-1991, the correlation between value and momentum has declined from –0.44 to –0.63, and, as a result, the Sharpe ratio of the combination of value and momentum has not changed much over time, since the increased correlation across markets is being offset by the more negative correlation between value and momentum.

Value and Momentum is the Holy Grail

– Value (low price to book value) • Rebalanced Annually

– Momentum (2-month to 12-month price appreciation) • Rebalanced Monthly

1971-2013 Period Cumulative Return

Value Stock Portfolio   55 Times Original Investment

Momentum Stock Portfolio 90% More Than Value

50-50 Combination Portfolio 100% More Than Momentum

380% More Than Value

Value and Momentum Sharpe Ratios (Risk Adjusted Returns)

Sharpe ratio = Excess return [R(x) – R(rf)] divided by standard deviation of R(x)

1971-2013 Period Sharpe Ratio

S&P 500

Value Stock Portfolio

0.40

0.73

Momentum Stock Portfolio 0.81

50-50 Combination Portfolio1.42

(75% higher than momentum alone)

Quality Matters

– Avoiding losers is the main determinant to investing outperformance and the best way to avoid losing stocks is to focus on quality.

– The definition of “quality” includes criteria such as low debt, high earnings profitability, persistent free cash flows, and revenue growth.

– Less than half of small-cap stocks outperform (44%), so rigorous analysis is needed to separate the winners from the losers.

1963-2013 PeriodHigh Quality

Annualized ReturnLow Quality

Annualized Return

Value Stocks   7.0%   1.6%

Momentum Stocks 5.6 0.9

My 6-Point Safety Rating System (i.e. Quality)

1) Piotroski F-Score of 6 or above

2) Beneish M-Score of -2.00 or more negative

3) Altman Z-Score of 3.0 or above (adjusted from last year’s 3.5)

4) Short Interest to Float Ratio of less than 10%

5) 10 Percent Insider Ownership or Recent Insider Buying

6) Beta of Less than 1.15 (adjusted from last year’s 1.0)

Best Definition of Price Momentum

• Asness uses performance between 12 months ago and 2 months ago, skipping latest month because of “one month reversal” phenomenon.

• 2011 study by University of Rochester professor Robert Novy-Marx concludes:– Intermediate-term performance between 12 months ago and 7 months

ago is what matters– Short-term performance between 6 months ago and 2 months ago is

non-predictive.

• 2013 study by Swiss researcher Amit Goyal concludes:– Novy-Marx conclusion that short-term price performance non-predictive

is wrong because of contamination by 2-month reversal effect (spillover from 1-month reversal effect). If you take out 2nd month performance, then 6-month to 3-month performance is predictive.

– My Conclusion: Use 12-month to 3-month performance (10 months). Penalizing 1-month and 2-month performance also makes sense.

Relative Performance of Roadrunner Portfolios

• Value Portfolio: 29.92 Percent (average return per stock)• Momentum Portfolio: 0.53 Percent• Momentum Portfolio is Not Working!

– Fault lies with me, not the momentum strategy.– Strategy requires monthly selling of underperformers, which I did

not do in my quest to reach 20-stock portfolio size.

• Solutions: – Now that portfolio has reached its maximum 20-stock size,

monthly selling of laggards will occur.– Mimicking of Value Portfolio’s industry-sector diversification and

correlation analysis will end. Not relevant to momentum.– Price performance will be only stock-selection criteria, with

tiebreakers based on safety rating system.

Relative Performance of Roadrunner Portfolios

• Value Portfolio: 29.92 Percent (average return per stock)• Momentum Portfolio: 0.53 Percent• Momentum Portfolio is Not Working!

– Fault lies with me, not the momentum strategy.– Strategy requires monthly selling of underperformers, which I did

not do in my quest to reach 20-stock portfolio size.

• Solutions: – Now that portfolio has reached its maximum 20-stock size,

monthly selling of laggards will occur.– Mimicking of Value Portfolio’s industry-sector diversification,

correlation analysis, valuation, and management quality, will end. Simply not relevant to momentum.

– Price performance will be only stock-selection criteria, with tiebreakers based on safety rating system.

Relative Performance of Roadrunner Portfolios (Page 2)

• Examples of current Momentum portfolio holdings that no longer qualify:

– CommVault Systems (CVLT)– LeapFrog Enterprises (LF)– WisdomTree Investments (WETF)– HMS Holdings (HMSY)– Ocwen Financial (OCN)

• Sort Momentum portfolio by column entitled “Price to 52-week High” in ascending order for most likely portfolio deletions.

New Momentum Price-Performance Criterion

• Maximize Formula:

– 12-month to 3-month price performance (must be at least 95th percentile)

Minus

– 2-month price performance (minus a negative is a positive)

Minus

– 3* 1-month price performance

Five Momentum Candidates: No. 1

SunEdison (NYSE: SUNE)-- $5.1 billion

•Company formerly known as MEMC Electronic Materials. •Developer of solar power plants for businesses and utilities. Plans to keep best new solar projects for itself rather than sell them.•Will soon be solar “pure play” as it plans to spin-off its silicon wafer semiconductor business in a $250 million IPO later in 2014.•Leader in FBR polysilicon and CCZ crystal technology.•Strong growth in megawatt installations at a compounded annual growth rate of more than 90% since 2009. Earnings are projected to growth at least 15% annually over the next five years.•Hedge fund manager David Einhorn is buying the stock and has a $35 price target.•Momentum Formula: 254.6

Five Momentum Candidates: No. 2

AerCap Holdings N.V. (NYSE: AER)-- $4.5 billion

•Aircraft leasing company (Netherlands) •92 customers in 50 countries•$15 billion in assets and 378 modern and fuel-efficient aircraft.•“Transformative” acquisition of AIG’s aircraft leasing division – International Lease Finance Corp. (ILFC).

– $6 billion discount to independent fair value assessment (i.e., $5 billion cost is half price).

– Order slot for new aircraft (Airbus 350, Boeing 787) near front of the line (early delivery, cheaper purchase prices).

– Will triple fleet to 1,400 aircraft and make company second-largest in the world (GE is first).

•Momentum Formula: 199.3

Five Momentum Candidates: No. 3

Caesarstone Sdot-Yam (Nasdaq: CSTE) -- $1.9 billion

•Israeli manufacturer of engineered quartz stone surfaces like kitchen countertops (cheaper than granite)

•Major housing markets: Australia, Canada, U.S.

•February 2012 IPO on Nasdaq

•Partnership with IKEA USA to be exclusive supplier of non-laminate countertops in U.S. market.

•Momentum Formula: 170.1

Five Momentum Candidates: No. 4

Arkansas Best (Nasdaq: ABFS) -- $991 million

•Top-five “less than truckload” freight carrier in the U.S.•68% of the nation’s freight tonnage is carried by trucks. •The deregulation of the trucking industry in 1980 has generated tremendous productivity  and efficiency gains.•2012 acquisition of Panther Expedited provides growth opportunity in asset-light logistics services.•Industry research firm FTR is “optimistic” about trucking in 2014 and its Trucking Conditions Index in February – weather adjusted – reflects the tightest truck market on record. FTR is warning shippers that any modest uptick rise in industrial activity could act as a “tipping point” to cause truck freight rates to skyrocket.•Momentum Formula: 153.6 Percent

Five Momentum Candidates: No. 5

comScore (Nasdaq: SCOR) -- $984 million•“Big data” company in Washington D.C.•Customers include five of the top six cable companies, seven of the top 10 credit card issuers, and five of the top six consumer banks in the world.•Evaluates over 1.5 trillion online user interactions each month spanning 172 countries.•Markets data via its Media Matrix subscription-based product mix for use in advertising, customer service, product development, and inventory management.•Revenue has grown at an average annual compounded rate of 10 percent over the past three years and there’s every indication that this pace will continue in 2014.•Momentum Formula: 150.5

Jim FinkChief Investment Strategist,

Roadrunner Stocks

www.RoadrunnerStocks.com

Options for Income

www.JimFinksOptions.com