The Foolish 8 Small-Cap Screen

Historically, small-capitalization companies have outperformed larger companies—even considering any additional risk that smaller companies exhibit. For this reason, they have long captured the attention of investors looking for tomorrow?s market heavyweights. With thousands of small caps to choose from, the process of finding the most promising small firms that warrant further research is a daunting task.

This is where stock screening can alleviate some of the burden, by allowing you to winnow the universe of stocks down to a manageable group that you can then analyze more closely.

A methodology for screening for small stocks was developed by David and Tom Gardner, founders of the Motley Fool (www.fool.com). Called the Foolish 8, their strategy uses eight criteria to look for profitable and rapidly growing small companies with strong price momentum. It?s partly based upon the premise that the lack of coverage and interest in small-cap companies presents a better opportunity to locate undiscovered, attractive investment candidates.

The original Foolish Small Cap 8 screen was designed to flag potential growth companies based upon a combination of market- and business-related factors. Recently, a revised version of the screen added elements of valuation and management effectiveness and relaxed the small-cap criteria.

This article will discuss how to apply Motley Fool?s original Foolish 8 small-cap screen as well as their modified version using AAII?s Stock Investor Pro fundamental stock screening and database program. Stock Investor Pro covers a universe of approximately 8,000 NYSE, Amex, and Nasdaq National Market, Nasdaq Small Cap, and over-the-counter bulletin board (OTCBB), or pink sheet, stocks.

First:    Last:    Email:

Foolish 8 Filters

As mentioned, the Foolish 8 screen consists of both market- and filters. The filters used to identify good businesses are as follows:

• Recent earnings and sales growth of at least 25%;
• Net profit margin of at least 7%;
• Positive operating cash flow; and
• Insider ownership of at least 10%.

The next three Foolish 8 screens narrow the universe of stocks from which the top companies may be located. These market-related factors are:

• Daily dollar trading volume between $1 million and $25 million;
• Share price of at least $7; and
• Relative strength greater than 90%.

Lastly, the Foolish 8 screen caps a company?s annual sales at $500 million, which is used to identify smaller companies. Table 1 lists the companies passing the original Foolish 8 screen using Stock Investor Pro with data as of December 12, 2003. The 16 companies are ranked in descending order by their 52-week relative strength percentage rank figure.

Small Companies

The most common method of analyzing companies based upon size is market capitalization—current share price times the number of shares outstanding for the company. This method considers the market?s assessment of the overall value of a company. However, for the Foolish 8 small-cap screen, small companies are defined as those that have annual sales of $500 million or less. This screen is designed not only to separate the small companies from the large, but also to orient the investor?s mind toward buying a company, not merely a stock. However, since sales are an industry-specific element, this screen will tend to eliminate companies in traditionally high sales, low-margin industries—such as grocery stores. The sales screen will also filter out larger companies selling at distressed market levels that a traditional market-cap filter may allow.

Requiring companies to have sales over the last four quarters (trailing 12 months) of $500 million or less narrows the initial database of 7,952 to 5,060 firms using Stock Investor Pro with data as of December 12, 2003.

Of the 16 companies passing the original Foolish 8 screen, USANA Health Sciences has the highest level of sales over the last 12 months at $178.9 million, while Technology Research Corp. marks the other end of the spectrum with sales of $21.9 million.

Growth

One advantage of focusing on smaller companies is that they tend to have a greater potential for high growth. It is much easier for smaller companies to grow sales and earnings. No company can sustain high growth rates indefinitely—eventually its size begins to weigh it down.

The Foolish 8 methodology looks for a minimum level of year-on-year growth in both sales and earnings of at least 25%. Instituting such a high growth requirement is one way of targeting quality small companies—provided the growth is sustainable.

The next criteria take a look at growth in both earnings from continuing operations—which excludes extraordinary items and discontinued operations—and sales over the last 12 months compared to 12 months? sales one year ago. A total of 3,518 firms have earnings growth rates in excess of 25%, while 1,368 companies have sales growth rates in excess of 25%. When these two filters are combined, only 904 companies pass, and the list of passing companies for the entire Foolish 8 screen is lowered to 684.

Among companies that ultimately pass the Foolish 8 screen, A.S.V., Inc. has the highest growth rate in sales over the last 12 months at 90.0%.

On the earnings side, KCS Energy, Inc. has the highest growth rate over the last 12 months, at 538.2%. However, when using growth rates as part of a screening methodology, it is important to examine the raw numbers once you have completed the screen. In the case of KCS Energy, earnings grew from a loss of $0.52 a share to the current trailing 12-month figure of $1.49. When the base figures are close to zero, or negative as in the case here, any growth in earnings per share on a percentage basis can be very high and not representative of future potential.

Bankrate, Inc. has the lowest 12-month growth rate in earnings from continuing operations at 42.5%.

Net Profit Margin

Net margin is the bottom-line profit margin that indicates how well management has been able to turn sales into earnings available to shareholders. It is computed by dividing net income by sales for the same period. Here, the screen looks for companies with a net margin of 7% or greater for the trailing 12 months.

Screening only for companies with a net margin of at least 7% returns 2,336 companies. Added to our screen, the Foolish 8 list of passing companies stands at 287.

Among those that pass the screen, Closure Medical Corp. outpaced the others with a net margin of 41.0%, meaning that 41 cents of every dollar of sales generated by the company is net income.

Since profit margins are in part affected by the industry in which a company operates, it is common to compare the margins of a company to those of its underlying industry or sector. For this reason, we also provide the median industry net margin for each of the passing companies in Table 1. Each company has a net margin that is at least twice as high as their industry?s median value.

Cash Flow

The next Foolish 8 small-cap filter deals with cash flow, specifically cash flow from operations, and requires that a company?s figure be positive in order to pass.

Cash flow from operations is found in the statement of cash flows and includes adjustments to net income, such as adding non-cash expenses (depreciation, amortization, etc.) and changes in working capital accounts, such as accounts payable, accounts receivable, and inventory.

For rapidly growing companies, the ability to control their working capital accounts often determines whether they succeed or fail. In order for small companies to continue growing, they need to find ways to fund inventories (a cash outflow that lowers operating cash flows) and collect on accounts receivable (increasing accounts receivable also lowers operating cash flows). While it is more common to hear of companies failing because there is not a market for their products, companies can also grow themselves to death.

Within the Stock Investor Pro database, 4,992 out of 7,952 companies have positive (greater than zero) cash from operations for the trailing 12 months (last four quarters).

Adding the cash flow filter to the Foolish 8 screen narrows down the universe of passing companies to 242.

Low Liquidity

One cost of investing in smaller companies is that their shares tend to be illiquid—the trading volume of the shares is low, and the spread between the stock?s bid and ask prices is high. If you own an illiquid stock and wish to sell it, you may have to discount the price to attract a buyer. Common screening strategies to avoid illiquid shares include requiring a minimum level of trading volume or requiring a minimum level of shares outstanding.

The Foolish 8 screen, on the other hand, actively seeks companies that the Motley Fool considers to be relatively illiquid. In doing so, it forces would-be investors into taking the extra time that is required to analyze small companies. Since low liquidity makes it more difficult to ?trade out of mistakes,? this screen requires caution and discipline in the analysis process. Lastly, since it may be difficult to sell an illiquid stock during bad times, an individual must have a longer-term investment horizon.

As a measure of liquidity, the Foolish 8 screen makes use of the average daily dollar trading volume. Volume is the total number of shares transacted. The daily average can be calculated using various time periods, but a daily average based on three months? trading is common. Average daily dollar volume reflects the current price of a stock multiplied by its average daily volume. In order for a company to pass the Foolish 8 screen, its average daily dollar volume must be between $1 million and $25 million.

In Stock Investor Pro, the average daily dollar volume is calculated by multiplying the average monthly trading volume over the last three months—which is divided by 20 to approximate the average daily trading volume—by the current stock price. In Stock Investor Pro, 3,116 companies have an average daily dollar trading volume greater than or equal to $1 million, and 7,150 companies (90% of the database) have an average daily dollar trading volume of $25 million or less. Combined, these two filters isolate 1,256 companies and after adding the average dollar trading volume constraints to the overall Foolish 8 screen, 118 companies remain. The average daily dollar trading volume shown in Table 1 is in thousands of dollars. USANA Health Sciences, Inc. has the highest average daily dollar trading volume at $19.22 million while Palomar Medical Technology ekes its way through with an average daily dollar trading volume of $1.17 million.

Insider Holdings

For the Foolish 8 screen, the Motley Fool looks for companies where insiders own at least 10% of their company?s stock. This requirement allows investors to see whether the interests of ?insider? shareholders are aligned with those of ?outsider? shareholders. They are, however, more interested in the issue of insider ownership than in the level of insider ownership.

As a rule, it is better that a company have some level of insider ownership than not. Who else better knows the future prospects of the company and how this may affect future stock price movement? Insiders are privy to information regarding new products, competition, and operating environment.

The Securities Exchange Act of 1934 defines an insider as an officer or director of a public company, or an individual or an entity owning 10% or more of any class of a company?s shares. Thus, the term ?insider? refers to a wide-ranging group including large shareholders, directors, and officers.

Although large shareholders are insiders in a legal sense, they are not privy to the same information that top-level employees of the firm have access to. Directors, as one may guess, are members of the company?s board of directors. Officers are those individuals at a company occupying the highest positions—CEO, chief financial officer, chief operating officer, president, vice president, and others. In Stock Investor Pro, the percentage of insider ownership is defined as the percentage of common stock held by all officers and directors as a group, and beneficial owners who own more than 5% of the subject company?s stock as disclosed in the most recent proxy statement. The database contains 5,518 companies where insiders or beneficial owners hold at least 10% of the company?s outstanding shares. Integrating this criterion into the Foolish 8 screen drops the list of passing companies down to 79. For those companies that made the final cut, A.S.V., Inc. has the highest level of insider ownership at 72.9%, and Ceradyne, Inc. has the lowest at 14.4%.

Price & Performance

While the Foolish 8 small-cap screen looks for attractive small companies, it does not want these companies to have a price that is too low. As a rule, the Motley Fool shies away from so-called penny stocks, which they term as stocks with a price per share of under $5. These companies, historically, have been prone to manipulation, and they tend to lack financial data.

The Foolish 8 screen raises the price requirement to $7 a share or greater. The Motley Fool believes that prices reflect fundamental aspects of a company. If, after implementing all of the filters of the Foolish 8 screen, a stock does not have a share price of at least $7, they believe it may be a sign of some underlying fundamental problem with the company.

In Stock Investor Pro, 4,490 companies have a per share stock price of $7 or greater; adding the criteria to the Foolish 8 screen eliminates only two companies, leaving 77.

Just as price reflects certain fundamental aspects of a company, so too does relative price strength. High price strength relative to the stock universe tends to show that the market is recognizing the company?s value and is driving up the price of the stock at a rate that is better than that of a majority of other stocks. The Foolish 8 screen looks for companies whose stock price has outperformed 90% of the stock universe.

The most common timeframe for examining relative strength is one year, or 52 weeks. Therefore, AAII?s version of the Foolish 8 screen requires that a company?s 52-week relative strength percentage rank value is 90% or greater. In other words, over the last 52 weeks, the stock has performed in the top 10% of the entire Stock Investor Pro database.

In Stock Investor Pro, 806 companies have a 52-week relative strength that ranks in the top 10% of the database. Adding this requirement to the Foolish 8 screen isolates 16 companies. Evolving Systems, Inc. ranks the highest in relative strength at 100% and Closure Medical Corp. ranks the lowest at 90%. Over the last 52 weeks, these companies? shares have gained 1,519% and 189%, respectively.

In recent years, moves by The National Association of Securities Dealers (NASD) requiring companies traded on the over-the-counter bulletin board (OTCBB) market to be current in their SEC filings before their shares can be quoted have made the OTCBB more reputable. However, the Foolish method of investing avoids these stocks.

For this reason, the AAII Foolish 8 screen eliminates companies that are traded over-the-counter, shrinking the universe to 5,956 companies. As the final component of the overall Foolish 8 screen, this requirement does not eliminate any additional companies, leaving us with the final roster of 16 passing companies presented in Table 1.

The Revised Foolish 8 Screen

As mentioned, recent adjustments to the original Foolish Small Cap 8 methodology include adding elements of valuation and management effectiveness as well as relaxing the filters used to isolate only small companies.

The modified Foolish screen makes use of several elements of the original screen:

• Recent earnings and sales growth of at least 25%;
• Net profit margin of at least 7%;
• Positive operating cash flow;
• Insider ownership of at least 10%;
• Share price of at least $7; and
• Stocks that are listed on an exchange (not traded over-the-counter).

Implementing these criteria using Stock Investor Pro, we are left with 197 companies. This serves as the starting point for implementing the revisions to the Foolish 8 screen. Specifically, the changes are as follows:

• Raising the revenue cap to $900 million from $500 million;
• Eliminating the $25 million daily dollar volume maximum limit, while keeping the $1 million or greater minimum requirement;
• Lowering the relative strength requirement from 90% to 50%;
• In addition to positive cash from operations, requiring that free cash flow must also be positive;
• Requiring that price-to-free-cash-flow to free cash flow growth ratio is less than or equal to 1.00; and
• Requiring that return on equity for the last four quarters (trailing 12 months) and for the each of the last three fiscal years is greater than or equal to 15%.

Table 2 lists the five companies passing the modified Foolish 8 screen. Companies are ranked in ascending order by their price-to-free-cash-flow to free cash flow growth ratio.

By relaxing the revenue cap and eliminating the upper limit on daily dollar trading volume, the revised Foolish 8 screen now captures both small- and mid-sized companies. Requiring companies to have sales over the last four quarters (trailing 12 months) of no more than $900 million instead of $500 million allows 5,608 companies to pass this filter, up from 5,060. Adding this criterion to the ?old? Foolish 8 requirements lowers our number of passing companies from 197 to 153.

Raising the revenue cap does not have a significant impact on the companies passing the screen, as Engineered Support Systems is the only company to have sales over the last four quarters (trailing 12 months) over the old limit of $500 million at $572.7 million. Randgold Resources Ltd. has the lowest level of sales at $145.9 million.

Just as lowering the sales restrictions widens the universe from which the revised Foolish 8 screen could draw, so too does eliminating the upper range for average daily dollar trading volume. With the original average daily dollar range of at least $1 million and no more than $25 million, 1,256 companies pass these criteria. With the revised requirement that average daily dollar volume be at least $1 million, 3,116 companies pass. When adding the new average daily dollar volume criterion to the revised Foolish 8 screen 57 companies now pass. Again, we find that relaxing the old Foolish 8 criteria does not impact the final list of passing companies. University of Phoenix Online has the highest dollar volume, but at $22.8 million is still below that of the old cap of $25 million. K-Swiss Inc. has the lowest average daily dollar volume at $9.6 million.

The revised Foolish 8 screen also lowers the price performance requirements. Companies passing the screen no longer have to have price performance that exceeds 90% of the database over the last 52 weeks. Instead, the bar has been lowered to 50%. The reasoning behind this change is that, while using the 90% level captures companies that the market recognizes as being strong, such a stringent criterion may be eliminating good companies that have not yet been able to generate strong stock performance. Therefore, the revised version of the Foolish 8 screen requires that a company?s relative strength 52-week percentage rank value is 50% or greater.

In Stock Investor Pro, 3,804 companies have a 52-week relative strength that ranks in the top 50% of the database. Adding this requirement to the revised Foolish 8 screen isolates 82 companies. Those companies passing the revised Foolish 8 screen still have had reasonably strong price performance relative to the overall database—USANA Health Sciences ranks the highest in relative strength over the last 52 weeks at 98%, and University of Phoenix Online the lowest at 77%.

Beyond trying to capture larger companies, the revised Foolish 8 screen also adds an additional element of financial strength by requiring that free cash flow for the last four quarters (trailing 12 months) be positive, in addition to positive cash from operations. Ideally, a company should not only cover the costs of producing its goods and services, but also actually produce excess cash flow for its shareholders. Cash flow from operations represents a good starting point for this type of analysis. However, beyond current production, a growing company must reinvest its cash to maintain its operations and expand. While management may neglect capital expenditures in the short term, there are fundamental negative long-term growth implications to such neglect. Free cash flow refines the cash flow from operations measure by subtracting capital expenditures and dividend payments from operating cash flow. While you can argue that dividend payments are not required, they are expected by shareholders and they are paid in cash, so they must be subtracted from cash flow to calculate a free cash flow figure. This free cash flow figure is considered to be excess cash flow that the company can use as it deems most beneficial. With strong free cash flow, debt can be retired, new products can be developed, stock can be repurchased, and dividend payments can be increased. Excess cash flow also makes a company a more attractive takeover target.

You may need to make adjustments to the free cash flow figure depending upon the company?s industry. For example, financials do not typically have large expenditures in brick-and-mortar property, plant, and equipment. However, they make significant investments in marketable securities, which are not considered in the standard free cash flow calculation. When looking at the cash flow of a financial firm, it would be best to examine total cash flow figures from the statement of cash flows.

Cyclical firms and companies with long development and construction cycles may have periods of slow sales, inventory build-up, and strong capital expenditures that occur over the normal course of business. A firm such as Boeing, which has a long development cycle for new planes, a long ramp-up period when starting production, and an extended and expensive product construction cycle, may show negative free cash flow until it starts to deliver its planes in quantity.

In Stock Investor Pro, 3,873 companies have positive free cash flow per share for the last four quarters (trailing 12 months). By adding this filter to the revised Foolish 8 screen, we cut the list of passing companies down to 68.

Whereas the original Foolish 8 screen is basically a growth-oriented approach, the revised Foolish screen adds a value slant by using a price-to-free-cash-flow to free cash flow growth ratio. This is similar to the more traditional price-earnings to earnings growth, or PEG, ratio that forms the cornerstone of many value-oriented screens. However, since earnings are subject to various accounting assumptions, many at the discretion of management, the more reliable free cash flow is used here. With the traditional PEG ratio, a value of 1.0 is considered fairly valued, and values greater than 1.0 indicate a stock that may be overvalued. Based on these basic rules, the revised Foolish 8 screen looks for companies with a price-to-free-cash-flow to free cash flow growth ratio less than or equal to 1.0. In Stock Investor Pro, the formula to create this ratio uses the growth rate in free cash flow over the last four quarters (trailing 12 months) in order to include companies that have recently turned in positive free cash flow. In addition, only those companies that have had positive growth in free cash flow over the trailing 12 months pass this filter.

In Stock Investor Pro, 1,796 companies have a price-to-free-cash-flow to free cash flow growth value that is less than or equal to 1.00. Table 2, which lists the companies that pass the final revised Foolish 8 screen, is ranked in ascending order by this ratio. Randgold Resources Ltd. has the lowest value of 0.03, as its free cash flow growth ratio over the last four quarters was 287.2%. University of Phoenix has the highest value of 0.48, with a free cash flow growth rate of 123.1% over the trailing 12 months. After adding this criterion to the revised Foolish 8 screen we are left with 43 companies.

Lastly, the revised Foolish 8 screen takes a page from Robert Hagstrom?s book on investing à la Warren Buffett: ?The Essential Buffett: Timeless Principles for the New Economy? (2001, John Wiley & Sons). According to Hagstrom, one of the elements that Buffett uses to measure company performance focuses on return on equity, instead of the more traditional earnings per share. Buffett does not take quarterly or yearly results too seriously when studying company financials. He finds it better to focus on three- to five-year averages to gain a feel for the financial strengths of a company. Buffett looks for strong and consistent return on equity that is achieved without excess leverage or accounting gimmickry.

Therefore, the revised Foolish 8 screen uses the same elements outlined by Hagstrom: The screen looks for return on equity of 15% or more over the last four quarters and for each of the last three fiscal years. As a group, these four filters are the most restrictive of the screen, with only 250 companies passing the set. When these criteria are applied to the revised Foolish 8 screen, we are left with our five passing companies in Table 2.

Company Characteristics

 

Figure 1. Performance of Screens CLICK ON IMAGE TO SEE FULL SIZE.

Based on backtesting performed over the past six years, both the Foolish Small Cap 8 and revised Foolish Small Cap 8 screens have outperformed the small-, mid-, and large-cap indexes by a wide margin over this time period (see Figure 1). While the original Foolish 8 screen generated negative returns in both 2001 and 2002, the revised Foolish 8 screen turned in positive gains in each of the past six years. In addition, the revised screen beat the S&P indexes in every year except 1998, when it was overshadowed by the S&P 500 and MidCap 400 indexes. On the other hand, the original Foolish 8 screen lagged the S&P MidCap 400 and SmallCap indexes in 2001 and 2002 and the S&P 500 and MidCap 400 in 1998.

The characteristics of the stocks passing the screens are presented in Table 3. The number of passing companies for both screens is below their historical averages: 27 for the Foolish 8 screen and nine for the revised Foolish 8 screen. The revised Foolish 8 screen has a slightly lower turnover—30%—than the 35% monthly turnover of the original Foolish 8 screen.

While we know that companies passing both Foolish screens must have strong short-term growth in sales and earnings, it is interesting to look at the companies? longer-term performance as well. We find that the median long-term growth rates are lower for the original Foolish 8 screen, with a five-year growth rate in sales of 8.5% and in earnings of 11.6%. For the revised Foolish screen, these rates are much higher—27.9% and 40.8%, respectively. For all exchange-listed stocks, the median long-term growth rates in sales and earnings are 8.6% and 3.3%, respectively. Despite the fact that the companies passing the revised Foolish screen have had higher long-term historical growth rates than the companies passing the original screen, analysts apparently are more optimistic on the prospects for those companies passing the original screen going forward. The stocks passing the original Foolish 8 screen have a higher expected future growth rate compared to the companies passing the revised screen, with estimated earnings growth rates of 26.3% versus 16.3%.

Given the solid levels of growth being exhibited by the passing companies of both screens, we find that, for the most part, these stocks exhibit valuation multiples that are well above the typical exchange-listed stock; the one exception is the price-to-free-cash-flow flow to free cash flow growth ratio. The median value for the original Foolish 8 screen of 0.18 is in line with that of all exchange-listed stocks. For the revised Foolish 8 screen, which requires that companies must have a price-to-free-cash-flow to free cash flow growth ratio value less than or equal to 1.00, the median value is only slightly lower at 0.15.

From a liquidity standpoint, the median average daily trading volumes for both Foolish 8 screens are greater than that of all exchange-listed stocks. For the original Foolish 8 screen, the median daily dollar trading value is $4.27 million, well below the $25 million cap set in the screen. With the revised Foolish 8 screen, however, the cap is eliminated and, as a result, the median average daily dollar trading volume jumps to $18.38 million. For all exchange-listed stocks, the median daily dollar trading volume is $1.22 million. Finally, the stocks passing the original Foolish 8 screen are showing higher relative price strength over the last 52 weeks. The companies on the original Foolish 8 list have outperformed the S&P 500 by 255% over the period, while the companies passing the revised Foolish screen have outperformed the S&P by 96%. However, as we showed earlier, the revised Foolish 8 screen handily beat the original screen in the long run.

Conclusion

Stock screening such as this is a useful way of identifying potential investment candidates. However, the Motley Fool stresses that the final list of companies passing the two Foolish 8 screens—or any list of passing companies you generate—is by no means a buy or recommended list. It is up to you to perform your own due diligence to decide whether the companies truly warrant your investment dollars. This is especially true with smaller companies, where the price of making a mistake tends to be greater than when dealing with larger firms.