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Tim & The Veteran chatting usually leads to trouble, and this time was no different. Diving into the Russell 2000 to see if there are actually any diamonds in the rough (RUT) is rarely advisable, but it happened anyway...
Over to The Veteran 👇
Last week we had a little bit of magic in the Discord chat when Tim vocalised what he called a random thought. He wondered if the diversification away from US equities, as especially evidenced recently by the performance of the Nikkei 225 index, had left the door open for rotation into US Small Caps.
By chance, (or perhaps subconscious design) I had a recent note on the subject of small, mid-cap stocks open on my desktop.
The crux of the note was that everything had gone wrong for US Small caps, which according to the note had gone from a 4.75% outperformance of the S&P 500 to a 7.35% underperformance.
Furthermore, RUT or the Russell 2000 index was down 29% from its November 2021 highs.
I shared these and some other insights in the chat.
Jefferies, the broker that published the note believe that these falls may be unwarranted. The justification?
Typically performance among small and mid-caps worsens when the balance sheets of those companies are weak. Which isn’t currently the case for these groups.
Jefferies laid the blame for some of the downturn at the door of ETF sellers who had redeemed $8.0 billion from ETFs that focus on size, since March.
Index ETF investors look to capture the broad brush strokes within an asset class leaving no real room for nuance, or thoughts about individual stocks.
Having looked at the comments and data I'd shared, Tim realised that his thinking about rotation into Small Caps wasn't as random as he first thought...
I pointed out that in general small-cap stocks tend to outperform their large-cap brethren over time over time.
A trait that was identified and formalized as the “size factor” among US stocks way back in 1981 by the University of Chicago‘s Rolf Banz PhD.
To illustrate this point the chart below plots the percentage change in S&P 600 Small cap index in black against the S&P 500 index drawn in red since 1995.
Quick as a flash Tim came back to say these arguments made a lot of sense and that these arguments meant that we were looking for "Diamonds in the Rut".
That struck me as a superb strapline and also as a call to action so I jumped off to screen the Russell indices-choosing the 3000 index for completeness.
To create a list of potential opportunities I used a series of fundamental metrics which I exported to a spreadsheet, then calculated the averages for each of the fields thus creating a series of benchmarks against which to screen the index constituents.
Given that we were looking at small caps I applied a less than $10bln market cap rule.
Then it was simply a case of looking for stocks that had readings above the average for key criteria... Such as >146% growth in 5-year earnings, a price-to-book ratio <9.4 times and forward PE ratio < 26, and EPS growth of >20%.
Finally, I looked at share price performance. Here I filtered the list into two groups.
Those that had underperformed the average three-month return (of -9.58%) and those that had outperformed it.
Stocks with underperforming three-month % returns
These lists are the first step in the process. A basis for further research into the merits of individual names, such as a deeper examination of their fundamentals or their respective charts.
Likewise, assessing the risk of ruin. Nobody should be buying banks in the current situation unless they've got a deep understanding of the balance sheet...
Time will tell how these stocks perform.
Time also has a bearing on my original comments. That there was magic in the Discord chat.
The exchange of ideas, information and data crystallised into a tangible opportunity in just a few minutes. Tim and I were sparking off each other despite being 1000 miles apart.
I didn't post the results of research and screening until a couple of hours later.
Partly because I was in the middle of creating a momentum gauge for the Nasdaq 100 (using YTD % gains and the ratio between new highs and new lows in constituent stocks) as part of the previous conversation, and of course, I had to walk the dog too.
Each day our small but growing community kicks the tyres of the market and our trading ideas and strategies. There are many such conversations that set us thinking and make us question our assumptions.
That’s what sets Macrodesiac apart from many other trading communities which tend to operate on a dogmatic follow-my-leader basis.
The added value that you can extract from Macrodesiac will far outweigh any fees you pay to be a member of a community in which we all grow together. Even battle-scarred veterans like me...