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Small-Company Investing Using the "Oberweis Octagon"

by Wayne A. Thorp, CFA

Small Company Investing Using The

You don’t need to be a spendthrift to be aggressive. That, at least, is the underlying belief of Oberweis Asset Management, which through its family of mutual funds, seeks rapidly growing companies and invests in those that they feel are attractively priced.

This is a process the company terms “AGARP”: aggressive growth at a reasonable price.

Guiding this process are eight points that make up the “Oberweis Octagon”:

 

  • Rapid annual growth in revenue;
  • Rapid annual growth in pretax income;
  • Low price-earnings ratio in relation to underlying growth rate;
  • Products or services that offer the potential for strong future growth;
  • “Favorable” recent trends in revenue and earnings growth, ideally showing acceleration;
  • Low price-to-sales ratio;
  • Review of company financial statements, especially the footnotes, to attempt to identify future problems; and
  • Strong price strength relative to the market.

Screen Performance

 

Figure 1.
Oberweis Octagon
Portfolio Characteristics
CLICK ON IMAGE TO
SEE FULL SIZE.

AAII created a stock screen that mimics this approach using AAII’s Stock Investor Pro fundamental screening and database program. The companies passing the Oberweis Octagon screen are posted to AAII.com, and the performance of these stocks invested in a hypothetical portfolio is tracked on-line. The exact set of screening parameters of the Oberweis Octagon screen is provided at the end of this article.

The Oberweis screen has outperformed the large-cap S&P 500 and the S&P SmallCap 600 indexes over the testing period, which began in January of 1998 (see Figure 1).

Overall, the Oberweis Octagon screen has generated a 454.4% cumulative return over the period from January 1998 through June 2006. In addition, the screen has posted positive returns in each year except 2002.

Profile of Passing Companies

The characteristics of the stocks passing the Oberweis Octagon screen are presented in Table 1, while Table 2 lists the current roster of passing companies.

The screen seeks companies experiencing rapid growth, yet that are still attractively priced. While the median price-earnings ratio of the stocks passing the Oberweis Octagon screen is higher than that of all exchange-listed stocks—20.1 versus 18.8—these same companies have a significantly higher median five-year historical growth rate in earnings per share of 26.8% compared to that of the typical exchange-listed stock, which is 11.4%. Looking forward, the consensus earnings growth rate over the next three to five years is also slightly higher for stocks passing the Oberweis Octagon screen.

The Oberweis Octagon screen selects companies with market capitalizations below $8 billion. The median market cap for the current group of passing companies is near the bottom-end of the range at $1.62 billion and is well above the $425.1 million median market cap for exchange-listed stocks.

The stocks passing the Oberweis Octagon screen as of mid-July have outperformed the S&P 500 by 57% over the last 52 weeks, while the typical exchange-listed stock has only been able to keep pace with the index over the same period. Thirty-three stocks currently pass the screen, well above the average of 19 observed over the last eight-and-a-half years.

Table 1. Personal Financial Ratios (Reasonable Assumptions)
Portfolio Characteristics (Median) Oberweis
Octagon
All
Exchange-
Listed
Stocks
Price-earnings ratio (X) 20.1 18.8
Price-to-book-value ratio (X) 2.94 2.07
Price-to-sales-ratio (X) 1.45 1.81
EPS 5-yr. historical growth rate (%) 26.8 11.4
EPS 3-5 yr. estimated growth rate (%) 15 14.6
Market cap. ($ million) 1,618.40 425.1
Relative strength vs. S&P (%) 57 0
Monthly Observations
Average no. of passing stocks 19  
Highest no. of passing stocks 44  
Lowest no. of passing stocks 2  
Monthly turnover (%) 41.5  

Passing Companies

Table 2 ranks the passing companies in descending order by their 52-week relative strength. The goal of the Oberweis Octagon is to identify rapidly growing companies in the early stages of their life cycles which, in turn, will generate excess long-term returns.

Rapid and consistent growth in earnings and revenues stands as the cornerstone of the Oberweis Octagon. Sales are important because they drive bottom-line growth (earnings), and because sales tend to be more difficult to manage or manipulate than earnings.

Over the last four quarters (trailing 12 months), Allis-Chalmers Energy (ALY) has had the highest sales growth rate of 131.7%. The company provides services and equipment to oil and natural gas exploration and production companies. Undoubtedly, the company’s recent success can be attributed to an increase in demand for its services with oil prices at all-time highs.

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The same can be said for Global Industries, Inc. (GLBL), which has the highest 12-month pretax income growth rate of 704.8% among the passing companies in Table 2. Global is an offshore construction company that provides marine construction and support services to offshore oil and gas companies. The company’s pretax income has risen to $83.7 million for the last four quarters, from $10.4 million over the same four quarters a year ago. Overall, fully one-third of the companies currently passing the Oberweis Octagon screen are involved in the exploration, drilling, or refining of petroleum or offer services to these activities.

To isolate reasonably priced companies from the universe of rapidly growing firms, the Oberweis Octagon screen makes use of a modified PEG ratio that compares the price-earnings ratio to the projected growth rate in earnings for the next year, which is the percentage change of forecasted earnings for the current fiscal year compared to the level of reported earnings for the last fiscal year.

Among the companies that passed the Oberweis Octagon screen, FreightCar America, Inc. (RAIL) has the lowest price-earnings ratio of 9.1. The company specializes in aluminum-bodied coal-carrying railcars.

Amkor Technology, Inc. (AMKR), a subcontractor of semiconductor packaging (assembly) and test services, has the highest price-earnings ratio, at 82.3.

 

 

Conclusion

No matter how well a stock screening methodology has performed (or how badly it has underperformed) over the long term, stock screening is only the first step in the stock selection process.

The stocks passing the Oberweis Octagon screen do not represent a “recommended” or “buy” list of stocks. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing tolerances and constraints before committing your investment dollars.

   What it Takes: Oberweis Octagon Criteria
The following criteria are applied separately to those companies with a market capitalization between $1 billion and $8 billion:

 

  • The growth rate in earnings per share from continuing operations over the last four quarters (trailing 12 months) is at least 20%;
  • The growth rate in pretax income over the last four quarters (trailing 12 months) is at least 20%;
  • The growth rate in sales over the last four quarters (trailing 12 months) is at least 20%; and
  • The price-earnings ratio is less than the projected earnings per share growth rate over the next year.

The following criteria are applied separately to those companies with a market capitalization less than or equal to $1 billion:

 

  • The growth rate in earnings per share from continuing operations over the last four quarters (trailing 12 months) is at least 30%;
  • The growth rate in pretax income over the last four quarters (trailing 12 months) is at least 30%;
  • The growth rate in sales over the last four quarters (trailing 12 months) is at least 30%; and
  • The price-earnings ratio is less than one-half of the projected earnings per share growth rate over the next year.

The following criteria are applied to those companies meeting the two separate sets of criteria outlined above:

 

  • The stock must be traded on the American, New York, or NASDAQ exchanges;
  • Earnings per share from continuing operations for the last fiscal quarter are greater than earnings per share from continuing operations for the same quarter one year ago;
  • Earnings per share from continuing operations for two quarters ago are greater than earnings per share from continuing operations for the same quarter one year ago;
  • Earnings per share from continuing operations for the last four fiscal quarters (trailing 12 months) are greater than or equal to earnings per share from continuing operations for the last fiscal year;
  • Sales for the last fiscal quarter are greater than sales for the same quarter one year ago;
  • Sales for two quarters ago are greater than sales for the same quarter one year ago;
  • Sales for the last four fiscal quarters (trailing 12 months) are greater than or equal to sales for the last fiscal year;
  • The price-to-sales ratio is less than the median price-to-sales ratio for the industry; and
  • The relative strength over the last 52 weeks ranks in the top quartile (25%) of all stocks.


Wayne A. Thorp, CFA, is financial analyst at AAII and editor of Computerized Investing.

Wayne A. Thorp, CFA is a vice president and senior financial analyst at AAII and editor of Computerized Investing. Follow him on Twitter at @WayneTAAII.


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