The first Foolish 8 screen to be examined is the annual revenue requirement of $500 million. "What's so special about annual revenues of $500 million?" you might say. Well, to be perfectly honest, nothing.
No statistical study that I'm familiar with shows that companies with less than the precise figure of $500 million in annual revenues have a historical penchant for outperforming the market. No notable academics that I've heard of have written dense research papers extolling the virtues of certain types of companies over others based exclusively on a $500 million annual revenue cut-off. From what I can gather, the $500 million revenue mark is not the River Styx that divides the world of stocks with vitality from the land of stocks with no pulse.
Pure and simple, the Foolish 8's $500 million revenue requirement is an arbitrary figure used to delineate small companies from large companies. In other words, companies with less than $500 million in annual revenues are considered "small" by our standards, while companies with more than $500 million in annual revenues are considered too "large" (or at least "not-so-small'). That's all there really is to it.
There is nothing special about the $500 million figure itself. In fact, in terms of the overall number of publicly traded companies, the requirement eliminates from the Foolish 8 consideration process, the $500 million revenue threshold isn't even an incredibly special screening tool. According to figures from Quicken.com, of the roughly 10,000 publicly traded companies on the U.S. markets, only about 2,000 can claim more than $500 million in annual revenues. So this "screen" more or less lets through 80% of the stuff that it is supposed to screen out. If this was a screen door, your house would have more flies than a zipper manufacturers convention.
So, what purpose does a $500 million maximum annual revenue requirement serve? Consciously (or perhaps unconsciously), it properly orients the Foolish 8 investor's mind toward what is really being examined here -- small companies. Companies have revenues, stocks do not. Far too often, the use of screening tools can warp an investor's mind into thinking that the object being put through its paces is simply a collection of letters forming a ticker symbol. Such a view is most unFoolish and for the most part is not conducive to long-run investing returns.
As a rather firm policy, The Motley Fool advocates that investors think about their stocks as representing share ownerships in real-world businesses, not ticker symbols that move up and down every trading day in the virtual world of our computer screens. True, there are some Foolish 8 screens that are based on market-related criteria rather than business-related considerations, such as the requirements for daily dollar volume and minimums for share price and relative strength. However, those particular screens serve unique and useful purposes, as will be fully addressed in later columns.
On the other hand, what does not generally serve a useful purpose under the Foolish 8 system is the traditional Wall Street way of separating small companies from large companies based on the measure of market capitalization alone. Dividing the stock market up into "small cap" and "large cap" land masses based on a capitalization line of demarcation is no less arbitrary a method than separating companies based on a revenue figure. And from a purely mathematical perspective, it hardly makes any difference. According to Quicken.com (again), the number of companies currently falling on either side of the $500 million market cap threshold is more or less equal to the number of companies on either side of the $500 million annual revenue divide.
So, what's the big deal with the concept of a small-cap stock? Why is it so common to hear market pros refer to "small caps" instead of "small companies?"
While there is no concrete evidence to back it up, one possible (and in my opinion, likely) explanation is that the terms small cap and large cap are mostly sales tools used by the Wise to divide the market into separate areas in order to induce investors to trade more frequently. This isn't some kind of dark conspiracy, mind you. It's just a selling strategy, a twist on the old "sector rotation" gambit.
Instead of creating groups of stocks lumped together by industry, referring to stocks as either small caps or large caps simply tosses random stocks together based on their market capitalizations. Either way, the end result is that stocks are broken up into different classes. This way, a broker can pitch a client that it is time to "rotate out" of one stock class in order to "gain exposure" to another (for whatever reason). In simple terms, this is similar to how individuals are advised to rotate their car tires or their mattresses from time to time.
However, stocks are not tires or mattresses. As I pointed out earlier, stocks represent share interests in actual companies. That point is worth keeping in mind throughout the stock selection process. And if the process is centered on the concept of becoming a partial owner in a business from the get-go, then much of the small cap versus large cap talk out there can be seen for the idle chatter that it truly is.
The main goal of the Foolish 8 method is to identify good small companies, regardless of what an oftentimes fickle market determines their capitalizations should be on a given day. Sure, it may just seem like a matter of semantics. In future Foolish 8 writings, small companies will be referred to as small caps as a matter of convenience. Yet, investors own shares in companies, not caps. That is the central rationale for starting with an initial Foolish 8 screen requiring $500 million annual revenues in favor of a certain level of market capitalization.
