Small growth stocks can be packed with potential, but any discussion of the market’s fast-growing little guys usually comes with a couple of important caveats: They can be risky and quite volatile. One year’s darlings can become next year’s dogs in the blink of an eye, making for a tumultuous ride.
But investing in small growth stocks doesn’t have to be an emotional roller coaster. If you use a thorough, well-rounded, fundamental-focused strategy, you should be able to limit some of your downside risk by steering clear of fast-growing paper tigers that are more style than substance. In fact, the best performer of all my individual Guru Strategies (each of which is based on the approach of a different investing great) has been a small growth approach — and it’s one that’s also been remarkably consistent and only slightly more volatile than the broader market.
The strategy is based on the approach that brothers and Motley Fool creators Tom and David Gardner laid out in their 1996 book The Motley Fool Investment Guide: How the Fool Beats Wall Street’s Wise Men and How You Can Too. Since I started tracking it in July 2003, a 10-stock portfolio picked using the Fool-based method has gained 466% (through April 27; all performance figures exclusive of dividends and fees). That’s 15.8% annualized during a period in which the S&P 500 has averaged annual gains of just 6.5%.
The Fool portfolio has made money in all but one of its 12 years, and the lone exception was 2008, when it lost far less (25.0%) than the S&P (38.5%). But last year it did struggle amid the small-cap sell-off, gaining just 1.6% while the S&P rose 11.4%. In 2015, it has bounced back with a vengeance, however, gaining 9.1%. All of this doesn’t mean that the portfolio will never have a big negative year — any strategy will from time to time fail. But the Fool approach has generated great returns with a lot less volatility than you might expect for a small growth strategy.
A Comprehensive Growth Approach
How has the approach fared so well in a variety of different environments? By being thorough — very thorough. While all of my models look at a variety of variables, the Fool-based strategy looks at more than any of them, examining about 17 different criteria.
And those variables run the gamut. Some, like 12-month relative strength (which should be at least 90), look at price and momentum. But most examine the stock’s underlying business, making sure that a strong and improving business is supporting the stock’s strong performance. After-tax profit margins should be at least 7% in the most recent year, for example — and margins should be consistent or rising over the past three years. Recent earnings and sales growth must also be strong, with both net income and revenue rising at least 25% in the most recent quarter.
The Fool-based model is also big on cash. It likes to see a positive free cash flow per share, and it really doesn’t like debt — a firm’s debt/equity ratio should be no higher than 5%. It also doesn’t want cash the company should be getting being held up in accounts receivable. If the accounts receivable/sales ratio grows by more than 30 percentage points in a given year, the strategy sees it as a warning sign.
One thing that I’ve found in my years of studying history’s most successful investing strategies is that the best approaches — even top growth models — include some sort of value criteria. The Fool-based model is no different, looking at the “Fool Ratio”, which is essentially the P/E-to-growth ratio — PEG — that Peter Lynch made famous. This ideally should be no greater than 0.5, though it can be slightly higher if the firm’s other fundamentals are excellent.
While it doesn’t have a market cap criterion, the Fool-inspired portfolio tends to focus on smaller stocks. That’s because it keys on stocks with less than $500 million in annual sales, daily dollar volumes no greater than $25 million, and prices below $20 a share, since those are the companies that tend to fly under the radar.
A couple final areas the Fool-based model examines: research & development budgets, which should be staying at the same level or increasing (particularly for medical and technology firms), and income taxes. If a firm’s amount of income tax paid last year is less than 20% of pre-tax income, that’s a red flag, signaling that profits may have been unrealistically inflated because of a low tax bill.
When you put all of this together, you get a rigorous growth strategy that is not easily impressed. Right now, only two stocks get “strong interest” (scores of 90% or above) from the Fool-based model. Here’s a look at them, along with three others that get very solid scores in the 80%-90% range.
Universal Insurance Holdings, Inc. (NYSE:UVE): Universal is a vertically integrated insurance holding company involved in insurance underwriting, distribution and claims. Its subsidiaries offer homeowners insurance in Florida, North Carolina, South Carolina, Hawaii, Georgia, Massachusetts and Maryland. The $900-million-market-cap firm is the only stock that currently gets a perfect 100% score from my Fool-based model, thanks to its strong recent growth (37% for EPS and 35% for sales last quarter), high and rising profit margins (11.2% two years ago, 19.6% a year ago, and 19.8% in the current year), and 94 relative strength.
Lannett Company, Inc. (NYSE:LCI): This 73-year-old Philadelphia-based firm ($2.4 billion market cap) makes generic prescription pharmaceutical products for customers throughout the United States. Lannett markets its products primarily to drug wholesalers, retail drug chains, distributors, and government agencies. Lannett gets a 91% score from the Fool approach. It has had very strong recent growth (147% for EPS and 71% for sales last quarter), a 0.4 PEG, and a 94 relative strength.
WisdomTree Investments, Inc. (NASDAQ:WETF): This asset management company ($2.9 billion market cap) focuses on exchange-traded funds, offering a family of ETFs that includes fundamentally weighted funds that track its own indexes, funds that track third party indexes and actively managed funds. WisdomTree gets an 85% score from my Fool-based model, which likes its 94 relative strength and 33% after-tax margins. It also likes the price: WETF has a PEG of 0.4.
Sagent Pharmaceuticals Inc (NASDAQ:SGNT): This global specialty pharmaceutical company ($800 million market cap) focuses on developing, manufacturing, sourcing and marketing injectable pharmaceutical products with a primary focus on generic injectable pharmaceuticals. Sagent offers customers a broad range of products across anti-infective, oncolytic and critical care indications in a variety of presentations, including single- and multi-dose vials and ready-to-use pre-filled syringes and premix bags. My Fool-based model gives the stock an 83% score, thanks in part to its 13.8% after-tax margins, big recent growth (728% EPS and 30% sales last quarter), and 0.7% debt/equity ratio
HCI Group Inc (NYSE:HCI): This Tampa-based small-cap ($500 million) P&C insurer has been rapidly growing its business in recent years as Florida officials called on state-run, not-for-profit Citizens Property Insurance Corporation to divest a substantial portion of its policies. That allowed firms like HCI to pick and choose the most profitable policies. HCI’s fundamentals are strong. The Fool approach likes its 24% after-tax margins, $6.49 in free cash per share, and 0.17 PEG. It gives HCI an 87% score.