There are two types of risks in small-cap investing, operational risk and price risk. Examples of both show up in a look at the subsequent performance of a Foolish 8 stock list from the past. From our historical data, it appears that only about one in ten Foolish 8 stocks can be expected to turn into a winner. However, it only takes a few big winners to make a small-cap investing career.
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Typically, I prefer to define risk as the chance that something very, very bad will happen in the future to a business or its market valuation. It may be easier to think of these two risks separately and refer to them independently, using terms such as "operational risk" and "price risk." You can get burned either way when investing in a business' stock, although sometimes the operational risk will outweigh the price risk while other times it will be just the reverse.
When buying shares of fast-growing small companies, there are often high degrees of both kinds of risks. First, factors like market illiquidity and momentum investing strategies can drive a small-cap's market valuation way too high relative to what the business will be able to do in the future. Also, a small-cap's growth rate could slow as it gets larger or as it runs up against bigger competitors, creating operational problems and hampering its future performance. In both cases, investors can expect the market price of the company to fall.
This risk double-whammy is the main reason why small-cap investing is not for everyone and why there is a "High Risk" disclaimer at the top of this column. By focusing on both the business- and market-related elements of a stock, we believe the Foolish 8 screening system can help a small-cap investor deal with some of this risk. However, it's far from a perfect system.
In fact, investing in the handful of stocks that pass through the Foolish 8 screens every month automatically and without doing any additional research is not just risky, it's downright asking for trouble. The Foolish 8 spreadsheet has been around long enough as a product that we can begin to back up this notion with real data. For a telling example, here's a look at the 12 stocks that appeared in the July 22, 1998 Foolish 8 spreadsheet and how they have performed since then:
Name Performance since 7/22/98 Acxicom (ACXM) 14.33% Cutter and Buck (CBUK) -50.22% Central Parking (CPC) -56.77% Doral Financial (DORL) 27.48% Financial Federal (FIF) -7.59% Mercator Software (MCTR) -17.71% Mesaba Holdings (MAIR) -50.59% META Group (METG) -74.29% ResMed (RMD) 269.97% Rent-Way (RWY) -85.55% Veritas (VRTS) 731.32% Zapata Corp. (ZAP) -90.37%
The July 1998 spreadsheet was chosen as an example for a couple of reasons. First, this was our second spreadsheet, so it provides one of the longest possible tracking periods. The performance figures represent 29 months of performance, which is about as close as we can get to the 36-month holding period we prefer to use for small-caps. Second, there is a good mix of companies from various industries represented, from clothing to software to financial services.
But most notably, the breakdown of the results is typical of what we have found from tracking the performance of the 193 companies that have appeared in the Foolish 8 spreadsheets over the past two and a half years as a whole. Yes, this a typical Foolish 8 list, not an extraordinarily bad one. That may sound shocking considering the sheer number of stocks on the list that ended up with negative performances in the past 29 months. But in reality, it's a fairly accurate microcosm of the entire Foolish 8 universe.
While there were only two big winners on the July 1998 list, Veritas and ResMed, there were plenty of stock performance dogs, including a few out-and-out disasters. This is pretty consistent with what we've found by looking at the results of all of the Foolish 8 lists we've published over the life of the product. Only about 10% to 15% of the companies that show up on the list will come close to doubling in three years, or turning in at least a 25% compounded annual return. (The number of Veritas-like performers is less than 3%.) But for every stock that doubles, roughly two will lose at least 50% of their value. That ratio was even higher in the July 1998 list, with three 50% (or worse) losers for every 100% (or better) gainer.
What's funny, though, is that a hypothetical individual who took the easy way out and bought all twelve of these stocks in equal dollar amounts in July 1998 and held them until today would have actually done okay. I recreated this situation using the portfolio tracker at Fool.com and came up with an annualized portfolio return of just under 16%, compared to the 5.3% annualized return of the S&P 500 over the same span. This market beating return is due to Veritas and ResMed, which by virtue of their dramatic appreciations over the past 29 months, ended up accounting for a whopping 66% of the mock portfolio's total value in the end.
A couple preliminary conclusions can be drawn from the above example and the performance data we have for the Foolish 8 lists so far. First and foremost, there are sizable amounts of operational and price risks associated with the fast-growing small companies that appear on the Foolish 8 list each month. An investor should approach the list aware of the high probability that the majority of the companies will turn out to be stock market losers, not winners. But on the flip side, the results point to the truth in the famous Peter Lynch statement that if you turn over enough rocks, you'll find a few gems. As the July 1998 Foolish 8 list showed, it only takes one Veritas to make up for a half dozen Cutter and Bucks. In future columns, our primary focus will be on how to find the former type of stocks and avoid the latter.
Want an idea of what a Foolish 8 stock looks like? Check out the Foolish 8 One-Click Scorecard at Quicken.com.
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