The Small Cap Strategy Returning 28% YTD


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Jae Jun

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Small Cap Strategy Returning 28% YTD

Small Cap Strategy

Small Cap Strategy

Small Cap Strategy – The Secret Sauce

The market has been on fire this year. Up 15% and still going strong. However, there is a small cap stock screening strategy that has appeared out of no where and has achieved a performance of 27% YTD.

The fact that this strategy is focused on value small caps means that the strategy is still flying under the radar, and I bet it will continue to fly under the radar.

The secret sauce used in the screen is centered on Net Net Working Capital aka NNWC.

Net Net Working Capital Background

The original concept of NNWC came from Benjamin Graham as he loved to pick up stocks trading at dirt cheap valuations. Put simply, NNWC stocks are those that trade below their net asset value. In the value world, these stocks are called “net nets”.

Net nets = dirt cheap stocks with problems causing it to sell at less than a discount to its assets.

The mathematical formula is:

Net Net Working Capital = Cash and short-term investments + (0.75 x accounts receivable) + (0.5 x inventory) – total liabilities

As  you can see, a net net must be in a dire situation to be selling below cash, 75% of accounts receivables, 50% of inventory minus liabilities.

But I lied.

This isn’t the strategy that is performing at 27%. The actual strategy is one where the stocks are seeing their NNWC value increase from the previous period.

This makes things a lot different.

The whole focus changes from finding cheap stocks, to finding cheap stocks where there is tangible evidence that the business is improving.

An unloved business which can increase its current assets faster than its liabilities is in a situation to turn it around.

If a stock is unloved as much as net nets, even slight positive news can send it rocketing up and that’s what has been happening with the NNWC increasing strategy this year. Note that this has some severe ups and downs.

Definitely not for the faint hearted.

Screener Set Up

I use portfolio123.com for my screening so here are the details of how I set it up.

  • Remove Chinese stocks
  • Remove ADR’s and financial stocks
  • Remove OTC stocks
  • Current quarter NNWC is greater than zero
  • Current quarter NNWC is greater than the previous quarter NNWC
  • Daily volume is greater than 30k

To do this yourself, here is the guide on how to backtest and screen using portfolio123.com.

The strategy has been under performing over the past couple of years, even during a rising market, so it is nice to see it trying to bounce back this year.

But it does go to show that it’s very difficult for any single screening strategy to beat the market year after year. However, with a longer term view, there is possibility of significant outperformance.

For the statisticians, here is a detailed look at how the portfolio has been performing this year.

The 2013 NNWC Increasing Stocks

I disagree with screens and strategies showing that you have to buy and sell stocks every 4 weeks.

It’s unrealistic to trade that often.

Instead, the value screens I post are rebalanced only once a year. Max holding is 20 stocks.

For the Small Cap Strategy, here is the list of 2013 NNWC increasing stocks doing so well this year. Let’s see if it can hold up for the rest of the year.

Note: ORCC buyout offer occurred on Jan 31.

Disclosure

None

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