In the interest of time (and in the interest of keeping things interesting), the Foolish 8 screens that relate to a minimum share price of $7 and relative strength of 90 or above will be considered together. Such a pairing doesn't make absolute nonsense, considering that both concepts deal with the sticky issue of stock price. Since price is a central consideration for any stock investor, it may be helpful to deal with the issue all at once and see how it relates generally to small companies.
Of all of the Foolish 8 screens, the two relating to price are by far the hardest to conceptualize. All of the other screens serve a specific purpose, seeing as they either orient the small-company investor to focus on a specific business issue or weed out those firms that lack some of the more desirable attributes of a good, small company. In other words, all of the other screens (excluding the daily dollar volume screen) deal in some way with what are often called business "fundamentals."
Why isn't market price considered a fundamental right along with such things as the net profit margin, operating cash flow, and revenue and earnings growth rates? Granted, a company only has limited control over its share price and relative strength, compared to the more direct control it has over the performance measures that end up on its financial statements. But to an investor, isn't the price to be paid for a company at least equally as important as these other items? In other words, isn't stock price a "fundamental," too?
The object here is not to split hairs over what is a fundamental and what isn't. The modern mind has a strong desire to categorize things into "clear and distinct ideas," as Descartes put it. But in investing, the desire to break up abstract investment concepts and examine them separately instead of looking at the entire business and market picture as a whole can lead to problems. Companies are not machines. They are more like living organisms, and thus properly analyzed holistically, rather than in parts. A doctor would not draw a line and categorize a patient's heart as a "fundamental" and his pancreas as something else. In the same vein, a company's share price is every bit as fundamental to an investor as the firm's margins or earnings growth rate.
The justification for the Foolish 8 screens requiring at least a $7 share price and a relative strength rating north of 90 lies in the belief that these two concepts reflect fundamental aspects of the business in some way. The key is to look at these two measures in conjunction with all of the Foolish 8 screens and not in isolation. Just as it is doubtful that a company growing earnings at a 25% clip and sporting at least a 7% net profit margin will not show positive operating cash flow (another of the Foolish 8 screens), a company with those same fundamentals is also unlikely to have a share price below $7. Anomalies do occur, of course. But if a small company meets all of the Foolish 8 screens except the $7 share price requirement, that can be a signal of some other fundamental problem at the firm.
Likewise, a relative strength reading greater than 90 can be viewed as an affirmation by the market of the strength of a company's fundamental story. If a stock has outperformed more than 90% of all other stocks in a particular universe over a certain period of time (which is what a relative strength reading of 90 signifies), then it is likely that the underlying company is doing a number of things right. The fact that the company in question has made it through the other Foolish 8 screens will back this up. High relative strength in this case may signify that a firm's fundamental value creation ability is being recognized by the market in the form of an outperforming share price. And that's a good thing for a small company, whose fundamental business performance has a greater chance of being missed by investors.
The important point is not to look at single-shot measures like share price or relative strength in a vacuum. This is especially the case with relative strength. You just can't buy stocks with high relative strengths on the sweeping generalization that "the winners will keep winning" and rationally expect high investment returns. But when combined with a few business performance measures, relative strength can serve a useful purpose in the small-company field, where past and present value creation is not always recognized right away by the market.
As a fellow Fool writer once put it, "Nothing is more fundamental about a stock than its price." Treating share price and relative strength as fundamental parts of a company's overall story, rather than isolated data points on a chart, is the way to go for the Foolish 8 small-cap investor. By themselves, neither a company's share price level nor its relative strength reading tell you much of anything. But when used alongside other business-related screens, these two measures can be fundamental telltales for the small-company investor.
[Motley Fool Research's Industry Focus 2001 features more on Foolish 8 small-cap stocks.]
