The Motley Fool's Small Cap Foolish 8 strategy seeks to identify small companies sporting very high sales and earnings growth, small market caps, and lots of stock price momentum. It's not an easy feat to pass muster with the Foolish 8. Just to qualify, a company has to have sales and earnings growth of at least 25%, must have profit margins of at least 7%, must be generating positive cash flow from operations, and must have a high proportion of insider ownership.
The combination of these very tough criteria tends to whittle down the universe of maybe 8,000 small-cap stocks to a very small number. From there, however, we overlay relative strength of 90, which means that the company must have been in the top 10% of all stocks in terms of stock performance over the previous six months, as ranked by Investor's Business Daily.
This typically brings us down to 10 stocks or fewer in an average month. The stocks left over, then, ought to be some of the best small-growth companies available. But not all of these stocks are winners. In many cases, it's because by the time they hit the relative strength requirement demanded by the screen, they've already appreciated dramatically in price.
I don't care much for relative strength, for reasons that I will get to in a minute. First let me discuss how and why relative strength got into the Foolish 8 screen in the first place. Relative strength is a concept that has been around for a long time, but probably the biggest backer is William O'Neil, the publisher of Investor's Business Daily and the author of many investing books.
O'Neil's system of investing, called CANSLIM, favors purchasing shares of small companies sporting very high sales and earnings growth, small market caps, and lots of stock price momentum. Sound familiar? In his book How to Make Money in Stocks, O'Neil exhorts his readers to avoid stocks with a relative strength under 70, noting that "the 500 best performing equities from 1953 to 1993 averaged a relative price strength of 87 just before their major increase in price actually began."
In the original Motley Fool Investment Guide, Tom and Dave Gardner compared investing to a horse race, suggesting that one "should bet on the pony that's in first place coming down the stretch, because who else is going to win?" A stock in motion tends to stay in motion, according to this theory of stock market gravity. Thus was the Foolish 8 stock screen born, combining O'Neil's growth and stock momentum criteria with Foolish criteria such as insider ownership, positive cash flow, and daily dollar volume.
It should be noted that I've studied the performance of the Foolish 8 stocks extensively, and as a group, these stocks had beaten the S&P 500 and the Nasdaq from the time TMF began producing the Foolish 8 spreadsheet in June of 1998 up until June of 2001, when I did the research. As part of the Foolish 8 screen, the relative strength requirement ensures that we invest in stocks that are already showing strong performance. It's also a handy way of cutting the list of surviving companies down to a manageable size. So if the system isn't broken, why fix it?
I'm not sure that we should fix it, necessarily. I'm just not sure that relative strength adds much value to the screen. First of all, O'Neil's system isn't just about buying fast-growing stocks with high relative strength, but rather emphasizes the selection of such stocks in combination with the use of technical analysis. In other words, market timing plays as big a role in O'Neil's system as the individual stock selection. In How to Make Money in Stocks, O'Neil spends 5 pages describing relative strength, and the better part of 35 pages discussing how to read charts and use various indicators to predict the short-term direction of the general stock market. His system also emphasizes being in the right market sectors and industries.
For example, in the section on relative strength, O'Neil doesn't stop at advising readers to choose high relative strength stocks, but rather to "pick 80s and 90s that are in a chart base pattern" and to be sure that the stock "is not extended (up) more than 5% or 10% above this base pattern." Later in the book, O'Neil addresses the question of whether his method constitutes momentum investing:
Some analysts and reporters, who have no idea at all how we invest, have referred to what we're doing as momentum investing and have said that it's buying the stocks that have gone up the most and that have the strongest relative price strength. No one in their right mind invests that way.
That is not what we're doing. We're buying companies with strong fundamentals, large sales and earnings increases resulting from unique new products and services and trying to time the purchases at the correct point as the company emerges from consolidation periods and before the stock runs up dramatically in price.
Ah. Buying strong growth companies before the stock runs up dramatically. That is the whole point, now, isn't it? This is my problem with relative strength. Whatever the advantages, they may be more than offset by the fact that stocks with extremely high relative strength have already appreciated more than similar stocks with lower relative strength. This makes it far more likely that we will end up overpaying for the stock.
Remember, we want companies showing fundamental strength, but we still want to buy them at a price that offers us a reasonable chance at a double in three years. O'Neil's system addressed this by using stock charts, and recommended that a stock should not be bought more than 5% or 10% above the "base pattern" in order to "prevent you from chasing stocks that have raced up in price too rapidly."
How should Foolish 8 investors avoid chasing stocks that have raced up in price too rapidly? It all comes back to valuation. Remember, the overriding reason to buy small cap stocks in the first place is to get better prices for high quality companies than are normally available in the blue-chip universe.
There's nothing wrong with buying a stock with a high relative strength if the valuation is still reasonable. In fact, that may be the best combination around. But investors should only plunk money down on a stock after ensuring that they thoroughly understand the business and are paying a reasonable price that offers a margin of safety. Use whatever analytical tools you fancy, whether it be forward-looking PE ratios, PEG ratio, price/free cash flow, or discounted cash flow spreadsheets, but make sure that you are comfortable with the valuation before you buy.
For those of you who use stock screening programs, it would certainly be worth your time to run a Foolish 8-style list without the relative strength requirement. That may be the best way to find the fast-growing companies before they begin their upward journey towards relative strength nirvana.
Zeke Ashton hopes to win the Whiffle Ball World Series some day. The Motley Fool is investors writing for investors.