Every month, The Motley Fool publishes a small-cap stock idea list using a quantitative screening process called the Foolish 8. And every month, the list of stocks generated by the Foolish 8 system changes. Some stocks appear on one month's list and fall off the next. A few have even followed the cycle of appearing on the list one month, falling off the next, and then reappearing a few months later. There is no rhyme or reason to the list. The only guarantee is a new collection of small-cap investment ideas each month.
The most common reason that stocks fall off the Foolish 8 list from month to month is due to the screen that requires a relative strength rating of 90 or higher. We've discussed the purpose of the relative strength screen in this space before, as well as each of the other Foolish 8 screening steps in detail. More than anything, a high relative strength rating is a handy way to keep the number of stocks that make it onto the monthly Foolish 8 lists to a manageable level.
Extremely high relative strength levels are not very common in the stock market. And when they do occur, not many stocks are able to maintain their stratospheric relative strength readings for months on end. Eventually, something will foul up high relative strength, be it a business-related event or the market's inherent fickleness. Pure and simple, no stock goes up in price forever.
Yet, there is a tendency for investors to associate a rising share price with a "good company" and a falling share price with a "bad company." This is only natural. In the everyday consumer world, the more desirable an item, the higher the price it can fetch in the marketplace. But this rule of thumb doesn't always apply in the stock market. Share prices and business values can get unglued from time to time, in both directions and usually only for short periods of time. Sometimes a moderately desirable company can, undeservedly, fetch a high share price for itself in the market. And likewise, every now and then a very desirable company's share price will sink for no good reason.
Long-term investors salivate whenever the latter situation occurs, especially if the slumping stock in question is attached to a business the investor understands well enough to make an attempt at estimating its fair value. This train of thought turns the concept of screening for stocks with high relative strength on its head. Instead, it suggests that long-term investors looking for bargains should actually screen for relative weakness, not relative strength.
Below is a list of Foolish 8 small-cap stocks that have dropped off the list in recent months as their share prices fell and their relative strength readings slipped below 90. What's interesting, though, is that since falling off the list, all of these stocks have kept right on falling in price. In other words, the list below shows small-cap stocks that have recently gone from showing high relative strength to moderate-to-high relative weakness:
Name and Drop-Off Price Current Price Ticker and Month Actuate (ACTU) $16.62 (Dec.) $12.37 Concord Camera (LENS) $15.06 (Dec.) $7.50 GBC Bancorp (GBCB) $35.34 (Jan.) $31.12 Hot Topic (HOTT) $32.12 (Dec.) $23.19 Manhattan Assoc. (MANH) $28.94 (Feb.) $23.50 MapInfo (MAPS) $27.56 (Feb.) $23.25 Pericom (PSEM) $21 (Nov.) $13.50 Serena Software (SRNA) $33.50 (Dec.) $14.12 $18.06 (Feb.) $14.12 Vicor (VICR) $38.50 (Nov.) $22.50
While buying a stock on relative weakness might not sound like an attractive strategy to some, there are certain advantages. A major one is that as a company's share price falls, so too do the earnings growth rates and multiples on those earnings needed to produce a desired future return. In short, the bar gets lowered. That's a good thing for a long-term investor. The lower the bar, the less a company needs to strain to get over it.
Just like in a marriage, having low expectations for a stock from the outset raises the chances that you'll be pleasantly surprised down the road and decreases the chances for a major, unforeseen disappointment. While lowered expectations due to relative weakness may not sound like such a good thing at first, they create opportunities for the long-term investor. Using a few of the small-cap stocks listed above as examples, we'll take a closer look at the interplay between relative price weakness, fair value, and future expectations in next week's column.
Before he started investing, Brian Graney thought the term "relative strength" referred to his uncle's handshake. You can see his holdings on his profile page. The Motley Fool is investors writing for investors.