In recent months, we've witnessed an interesting phenomenon with the Foolish 8 small-cap screening tool -- companies are falling off the Foolish 8 radar in droves, and those companies are not being replaced by new ones that pass muster with the screen. To be blunt, the Foolish 8 list is shrinking!
As recently as May, there were 20 or more stocks on any given day put forth by the Foolish 8 screen as potential investment ideas in the small-cap universe. Today, however, there are only six companies that currently meet all eight of the Foolish criteria, including some of the "usual suspects" from the last year such as auto auctioneer Copart (Nasdaq: CPRT) and consulting firm Clark/Bardes (Nasdaq: CLKB).
So with the equity markets tanking and stocks down across the board, is the relative strength part of the Foolish 8 screen to blame? To be certain, the answer is a resounding, "No!" The key word in this particular measuring tool is the "relative."
If a stock stays flat while the rest of the market dives, it is still doing better relative to the market. In today's environment, a stock can have fallen in recent months and still have actually done better than average, giving the stock a comparatively high relative strength. Remember, relative strength measures how a company's stock is doing relative to other stocks, and it does not measure absolute gains or losses created by individual stocks.
The more problematic hurdles for companies going through the Foolish 8 screen are the sales growth and earnings growth requirements. The Foolish 8 looks for companies that are growing both their top and bottom lines by at least 25% year-over-year, and this is becoming an increasingly difficult task given the economic environment we're in today.
It won't get any easier to pass this hurdle in the near term. When companies come forward over the next few weeks and report how they did in the third calendar quarter, the number of them passing the sales and earnings growth hurdle is likely to drop even further. This is because the third quarter was one where we saw the economy decelerate to its slowest pace in years, and the terrorist attacks only exacerbated the situation.
What to do?
So should we just trash the Foolish 8 screen in recessionary times due to its decreased output? Hardly. If anything, we should pay more attention to the Foolish 8 because the output of the screen is likely to be of much higher quality.
Just think, achieving 25% sales and earnings growth is commendable when economic times are good, but doing it in an environment such as today is downright impressive. For all practical purposes, the hurdles imposed by the Foolish 8 are the highest they've been since the screen was conceived a half-dozen years ago, and those companies that can pass these rigorous tests deserve to be looked at much more closely than companies put forth a year or two ago in the times of milk and honey.
Moreover, companies that can achieve positive earnings and cash flow today are proving their resilience and thick skin against the economic environment. Instead of being economically sensitive with cyclical earnings, companies staying above water today are likely to do that much better when the economy as a whole gets back on track.
As they say, observing someone in the worst of times often gives a clearer picture of their true skills and strengths than observing them when times are good and weaknesses can be easily masked. The same can be said of companies. Right now, we are in some of the worst economic times of recent memory, and now is an excellent time to find companies that are truly strong and able to weather the storm.