MARKET COMMENT
Picking Small Company Winners

By Bruce Jackson (TMFGoogly)
June 4, 2004

Small company shares were the place to be last year. Of the 341 companies in the Small Cap Index, just 37 fell in price in 2003. Put another way, a whopping 89% of all companies in the Small Cap Index saw their share prices rise in 2003.

Given that statistic, if you were a small company investor, unless you were unlucky or just a very bad stock picker, you couldn't help but make money in 2003. Well done.

Given that, many investors, battered by the bear market of the previous 3 years, thought they'd re-discovered their long lost stock picking skills. The reality is that most people remain poor stock pickers. If you've ever heard of the saying 'a rising tide lifts all boats' you'll know what I'm talking about. Most small cap investors were lucky, not necessarily good stock pickers.

This year brings a different challenge. To date, only 48% of Small Cap Index constituents have risen in 2004. Now I realise 5 months is a relative short amount of time over which to judge performance, but it's clear to see there's no rising tide this year. To make money in 2004 you are going to have to be a good stock picker. The same is likely to go for 2005, 2006, 2007, 2008 and beyond. Years like 2003 come along very rarely.

If I'm going to live by the sword, having stuck my neck out and said most Small Cap investors are not necessarily good stock pickers, I should be prepared to die by the sword. Without further ado, here's my formula for picking small company winners, with a couple of share picks thrown in for good measure. In the next 12-18 months, this should prove whether I'm just a big mouth writer and one of the many "not necessarily good stock pickers" I refer to above, or whether I can back up my writing with results. Wish me luck...

My Winning Formula

Well, it's not actually a formula, because fixed formulas rarely work on the stock market. It's more like a set of guidelines...

• Look for value shares. Value investing is the style most likely to give you consistent long-term success. In my view, a low price-to-sales ratio (PSR) is not a bad place to start looking for value shares.
  
• Look for companies going through temporary bad patches. Turnaround plays. A typical situation would be a company where profits have fallen by say 80% on sales down say 10%. In a turnaround play, as long you're not looking at a long-term sales decline, a return to previous levels of profitability is distinctly possible.
  
• Look for companies moving from loss into profit. The percentage growth rates can be explosive, leading to a low prospective price-to-earnings ratio (P/E).
  
• Look for 75%+ potential share price appreciation over the next 12-18 months.
  
• As our resident value investing expert Stephen Bland (TMF Pyad) says make sure the "smell" is right. This is the great intangible. For me, it involves looking at a company's accounts, feeling good about the management, some understanding of what they do and how they make money...lots of things. The company has to smell right. Get it? If not, ask Stephen. Alternatively, sign up to a free 30-day trial of Stephen's Value Investor newsletter, where you can download his free Unique Value Principles report. It smells good!
  
• Once you've identified a company, calculate its 'steady state' earnings potential, slap on a 'steady state' but conservative P/E ratio, and presto, you're onto a potential winner. Easy hey?

Do I Live or Die?

Find out on Monday. This article is already far too long for the Internet. To make sure you don't miss out on this life-threatening stunt, where I'll attempt to pick some future Small Cap winners, sign up to receive our lunchtime email, sent direct to your in-box at midday Monday to Friday. In the meantime, I'm checking out lots of small company value shares, and you're probably sharpening your swords!

Next
Sign up to a free 30-day trial to Stephen Bland's Value Investor newsletter.