An Aggressive Value Approach for Small-Company Investing
A case in point is Oberweis Asset Management, which, through its family of mutual funds, seeks out rapidly growing companies and invests in those that they feel are attractively priced, a process they term AGARP: aggressive growth at a reasonable price.
This article will walk you through the guidelines Oberweis uses in their process, while creating a stock screen that mimics the approach. AAII’s Stock Investor Pro fundamental screening and database program was used to construct the screen. Stock Investor Pro covers a universe of over 9,000 NYSE, Amex, Nasdaq National Market, Nasdaq Small Cap, and over-the-counter bulletin board or pink sheet stocks. Table 1 is a listing of the six companies that passed the Oberweis screen.
Oberweis uses eight primary rules in their approach, which they term the “Oberweis Octagon.” The eight tenets are:
- Rapid annual growth in revenue (sales),
- Rapid annual growth in pretax income and earnings per share,
- Products or services that offer the potential for strong future growth,
- “Favorable” recent (quarterly) trends in revenue and earnings growth, ideally showing acceleration,
- Reasonable (low) price-earnings ratio in relation to underlying growth rate,
- Reasonable (low) price-sales ratio,
- Review of company financial statements, especially the footnotes, to attempt to identify future problems, and
- Strong price strength relative to the market (high relative strength).
The Oberweis approach begins by limiting the universe of stocks to micro-, small-, and mid-cap companies. They generally define micro-cap companies as those with a market capitalization (stock price multiplied by number of shares outstanding) of under $150 million, small-caps between $150 million and $1 billion, and mid-caps as those companies with a market cap of $1 billion to $8 billion.
By focusing on smaller companies, Oberweis is attempting to find companies with a greater potential for high growth. No company can sustain a high growth rate indefinitely—eventually its size begins to weigh it down. Large companies simply cannot sustain the high growth rates that smaller, fast-growing companies can.
It is important to point out that there are unique risks to investing in small companies. Some of these risks include limited product lines, markets, and financial resources. Furthermore, the stocks of small companies tend to be more thinly traded than the stocks of larger, more established companies. Therefore, the prices of these stocks can be subject to sudden and significant movements. For this reason, Oberweis stresses the importance of investing in a diversified portfolio of small companies.
This Oberweis screen is actually two screens in one. It focuses on “small” companies with market caps of $1 billion or less, and “medium” companies with market caps between $1 billion and $8 billion. In Stock Investor Pro, there are 7,407 companies with a market cap less than or equal to $1 billion, and 1,196 firms with a market cap between $1 billion and $8 billion.
Therefore, the initial universe of stocks for the Oberweis screen is 8,603 companies out of 9,055. Of the six companies that passed the final Oberweis screen, Mylan Laboratories has the largest market cap, $3.85 billion, while Central European Distribution has the lowest market capitalization of $53.2 million.
|Company Name (Exchange: Ticker)||Market Cap. ($mil)||Sales Grth 12 mo.(%)||PreTax Income Grth 12 mo.(%)||EPS Cont Grth 12 mo.(%)||EPS Est Grth 1 yr.(%)||Price-Earnings Ration (X)||Price-Sales Ration (X)||Relative Strength 52 wk. (S&P=0) (%)||Description|
|115.4||46.7||209.3||194.1||83.9||36.5||4.4||537||Pharm & health-related prods|
Central European Dist.
|53.2||56.3||200.0||161.1||89.7||21.0||0.3||352||Import & distrib alcoholic bevs|
D&K Healthcare Resources
|382.9||37.0||73.7||30.9||31.7||22.4||0.2||223||Wholesale drug distrib|
|146.8||75.9||412.0||224.2||45.7||31.7||3.0||68||Discovery servs life sciences|
|2,961.3||178.0||252.9||141.3||195.2||34.8||0.2||55||Health benefit manage servs|
|3,851.3||31.6||486.0||469.7||94.2||16.5||3.6||42||Pharm & wound care prods|
*Source: AAII's Stock Investor / Market Guide, Inc. Data as of March 1, 2002
Rapid and consistent growth in revenues and earnings, stands as the cornerstone of the Oberweis Octagon. Sales are examined because they drive earnings, and because sales are more difficult to manipulate than earnings. For small-cap companies, Oberweis looks for growth in revenues of at least 30% over the trailing 12 months, while medium-sized companies must have revenue growth of at least 20%.
Oberweis also seeks similar growth in pretax income and earnings per share. Therefore, they want small companies to have grown pretax income and earnings per share by at least 30% over the trailing 12 months and mid-cap companies by at least 20%.
Ideally, Oberweis likes to see this growth generated internally and not through acquisitions. While a company can boost sales and earnings by acquiring other companies, eventually all of the “good” companies will be assimilated and further acquisitions will have a negative impact on the company.
These growth screens narrowed down the initial universe of 8,603 companies to 549: 141 small-cap companies and 408 medium-sized companies met the requirements.
As shown in Table 1, many of the companies passing the Oberweis screen have had triple-digit growth in sales, pretax income, or earnings per share over the last 12 months. AdvancePCS has the highest growth rate in sales with 178%; Mylan Laboratories leads all companies with pretax income growth of 486% and earnings per share growth of 469.7%. It is interesting to point out, however, that while Mylan had the highest growth rates in pretax income and earnings per share over the last 12 months, it had the lowest sales growth rate over the same period, of 31.6%. In the short-term, such a disparity can occur due to cost cutting and improved efficiency. However, in the long run, it is sales growth that will power earnings growth.
The next step is to identify companies with the potential for future growth.
While much of the Oberweis stock selection process is relatively “mechanical,” some elements are subjective in nature. One of them involves identifying the future growth potential of a company, focusing on companies with products or services that offer the potential for “substantial” future growth.
Just because a company is growing rapidly now does not necessarily mean that this growth will continue. Companies that produce quality products, are able to expand the market for their products, possess some natural barrier to retard competition, and can efficiently produce and market their products, are well positioned for prolonged growth. So, too, are companies that carve out a unique niche for themselves and dominate that niche. This enables them to insulate themselves from competitive pressures that typically erode sales and earnings growth. These niches can be geographical in nature, protection from competition through patents or government regulation, or simply a strong marketing presence that makes it cost-prohibitive for new competitors to enter the market.
Although this is an important element of the Oberweis approach, its mechanical nature does not lend itself to a screen, and we are therefore still left with the 549 firms identified from the growth screens.
Having already identified companies with strong growth, Oberweis looks for companies showing favorable trends in sales and earnings, ideally with accelerating growth in both of these areas. Furthermore, they attempt to locate companies that are in the early stages of acceleration. For these companies, there is the potential for price increases not only as a result of the rapid growth, but also because of price-earnings multiple expansion.
The screening criteria focusing on “favorable” trends in earnings and sales require that both sales and earnings per share from continuing operations for the last fiscal quarter be greater than they were for the same quarter one year prior. Furthermore, sales and earnings from the prior fiscal quarter must be greater than they were for the same quarter one year prior. Focusing on same-quarter results instead of quarter-to-quarter figures bypasses any seasonal fluctuations earnings and sales may undergo during the operating cycle. Screening for quarterly acceleration in sales resulted in 3,104 passing companies. There were also 2,724 companies with accelerating same-quarter earnings. Adding these screening elements to the prior growth screens resulted in 331 passing companies.
Additionally, the screen looks at the annual results for a company. More specifically, it requires that sales and earnings per share from continuing operations for the last four quarters (12 months) be greater than or equal to what they were for the last fiscal year. Here, 4,805 companies maintained or increased their sales, while 5,182 did the same for earnings per share. Adding this screen to the prior screens brings the list of passing companies down to 272.
Identifying rapidly growing companies with prospects for continued growth in the future is only part of the Oberweis stock selection methodology. From the universe of aggressively growing companies, they seek those that are reasonably priced. Specifically, they look at stock market valuations—especially the price-earnings and price-sales ratios.
Low Relative Price-Earnings Ratio: The cornerstone of many value-oriented investment strategies focuses on the price-earnings ratio. This is the ratio of earnings for the last four quarters (12 months) to the current stock price. Another compares the price-earnings ratio to the growth rate (either historical or projected) in earnings, which is called the PEG ratio. Oberweis looks for companies that have a “reasonable price-earnings ratio in relation to the company’s underlying growth rate.” More precisely, they compare the current price-earnings ratio to the projected growth rate in earnings for the next year. This growth rate is calculated by comparing the level of reported earnings from the last fiscal year to the estimated earnings for the current fiscal year.
For smaller companies, Oberweis requires the price-earnings ratio to be no more than one-half the projected growth rate, while for medium-sized companies, the price-earnings ratio cannot exceed the projected growth rate in earnings. As stand-alone screens, 489 small-cap and 65 mid-cap companies met these requirements. After adding this screen to the prior screens, 38 companies remained.
Among those companies that passed the Oberweis screen, Mylan Laboratories has the lowest price-earnings ratio at 16.5, while the highest price-earnings ratio of 36.5 belongs to Bradley Pharmaceuticals.
Low Price-Sales Ratio: The other value element of the Oberweis approach deals with the price-sales ratio. Similar to the price-earnings ratio, this ratio compares the current stock price to the sales of a company. Again, they look for companies with “reasonable price-sales ratios based on the company’s underlying growth prospects and profit margins.” In general, they do not wish to pay too much for a company’s current and potential growth.
As was the case for the price-earnings ratio, looking at absolute values for the price-sales ratio will not yield beneficial results. With any type of ratio analysis, it is best to compare ratios on a relative basis, such as against the overall market, sector or industry benchmarks, or against historical values. This screen, therefore, compares a company’s price-sales ratio to that of its industry. The screen requires that the current price-sales ratio be less than the median value of the price-sales ratio for the respective industry. This criterion yielded 3,831 companies and, adding it to the prior screens, 12 companies remained. D&K Healthcare Resources and AdvancePCS share the lowest price-sales ratios with 0.2. Bradley Pharmaceuticals has the highest price-sales ratio of 4.4.
|Approach: Investment in rapidly growing companies that are attractively priced.|
|Oberweis Octagon||Screens Applied to Implement Approach|
|Stock Universe: Focus on smaller companies in an attempt to find companies with a greater potential for high growth. Oberweis focuses on micro-caps (firms under $150 million in market capitalization), small caps ($150 million to $1 billion in market cap) and mid-caps ($1 billion to $8 billion).||Stock Investor database used as stock market universe; stocks that trade on the over-the-counter markets were excluded. Screens for small-cap stocks were applied to firms with market capitalizations of $1 billion or less; screens for mid-cap stocks were applied to firms with market capitalizations of between $1 billion and $8 billion.|
|Rapid annual growth in revenue (sales).||Sales growth of at least 30% over the trailing 12 months for small caps; 20% for mid-sized companies.|
|2) Rapid annual growth in pretax income and earnings per share.||Pretax income and earnings per share growth of at least 30% over the trailing 12 months for small caps; 20% for mid-sized companies.|
|3) Products or services that offer the potential for strong future growth.||Subjective judgment, no screen applied.|
|4) "Favorable" recent trends in revenue and earnings growth, ideally showing acceleration.||Sales per share and earnings per share from continuing operations for the last fiscal quarter must be greater than they were for the same quarter one year prior; and one year prior figures must be greater than the same quarter one year prior to that. Also, sales and earnings per share from continuing operations for th last four quarters must be greater than or equal to what they were for the last fiscal year.|
|5) Reasonable (low) price-earnings ratio in relation to the underlying earnings growth rate.||For smaller companies, the current price-earnings ratio must be no more than half the projected earnings growth rate for the next year (based on reported earnings from the last fiscal year and estimated earnings for the current fiscal year); for medium-sized companies, the price-earnings ratio cannot exceed the projected earnings growth rate.|
|6) Reasonable (low) price-sales ratio.||Current price-sales ratio must be less than the median price-sales ratio for the industry.|
|7) Review of company financial statements, especially the footnotes, to identify future problems.||Subjective judgment; no screen applied.|
|8) Strong price strength relative to the overall market (high relative strength).||52-week relative strength figure in the top 25% of the entire stock database.|
The Oberweis approach is interested in the current performance of a company yet keeps a watchful eye to the future. This is reflected in the way they attempt to identify companies that are positioned in their industry to continue their growth into the future. Another way in which Oberweis looks to the future is through careful examination of a company’s financial statements. Specifically, they review company balance sheets and 10-K and 10-Q reports filed with the SEC, paying close attention to the footnotes that accompany these statements.
Beyond examining the raw data contained within the financial statements, an important component of financial statement analysis deals with the footnotes to the statements. The footnotes serve to augment the information provided in the financial statements and contain supplemental data and disclosures. Footnotes provide information about the accounting methods used as well as management’s underlying assumptions and estimates. Disclosures found in the footnotes typically relate to areas such as fixed assets, inventories, pension and other post-employment benefit plans, lawsuits and other contingencies, marketable securities and other investments, and significant customers and sales to related parties.
Again, we are confronted with an element of the Oberweis screen that cannot be performed by a mechanical screen. This point underscores the need for additional analysis once you have applied any type of mechanical screen to a universe of stocks.
As a piece of conditional criteria, the Oberweis screen does eliminate those companies that trade on the over-the-counter market. Doing so isolates those companies that meet the size, share availability, financial strength, and/or filing requirements to be listed on the New York, American, Nasdaq National Market, or Nasdaq Small Cap Market. In Stock Investor, 6,755 companies are traded on the major exchanges. Combining this screening element with the other criteria, 12 companies still remained.
Just because a company appears to be a good investment on paper, does not mean that the market will agree and drive the price upward. Oberweis agrees with that statement and, therefore, does not “fight City Hall.” In other words, they only invest in companies with strong price performance relative to the overall market. Specifically, they look for companies that have outperformed at least 75% of the other stocks in the market in terms of price movement over the last 12 months. Therefore, the Oberweis screen requires a company to have a 52-week relative strength figure that ranks in the top 25% of the entire Stock Investor database. From the entire Stock Investor database, 2,212 companies rank in the top 25% of companies that have 52-week relative strength value. The final tally of companies passing all of the Oberweis screening criteria is six. Of these six companies, Bradley Pharmaceuticals has performed the best relative to the S&P 500, over the last 52 weeks with a relative strength of 537. Mylan Laboratories, which has the lowest relative strength value of the last 52 weeks, still outperformed the S&P 500 by 42%.
Stock screening is only an initial step in the investment process. Applying a methodology to a universe of stocks leaves you with a more manageable number of stocks to investigate closely. Furthermore, investing in small- and medium-sized firms carries with it a larger amount of risk than that involved when investing in larger, more-established companies.
By following the Oberweis approach, you may identify small- and mid-sized investment opportunities for inclusion in a diversified portfolio.