With the FTSE Smallcap index leaping by 20% this year, good quality small cap companies trading at attractive prices are proving harder to find. But despite a rash of surging share prices, there are still ways of finding potentially strong companies with eye-catching valuations. For the investor prepared to kick a few tyres in the search for shares that may be misunderstood or hidden from view, the smaller end of the market is a lucrative hunting ground for opportunities that others are missing.
Quality stocks at cheap prices have an obvious appeal to investors and unsurprisingly there are plenty of well-known investing strategies devoted to finding them. But as Ed wrote recently, one of the most famous strategies – Joel Greenblatt’s Magic Formula – has recently been called into question by researchers Dr Wesley Gray and Tobias Carlisle in their book Quantitative Value. Greenblatt, a successful hedge fund manager, introduced the Magic Formula in his 2005 book The Little Book That Beats the Market and investors quickly got hooked on its simplicity of ranking stocks based on two simple metrics (read more about that here).
The trouble with the Magic Formula is that while Greenblatt claimed a return of 30.8% every year for 17 years to 2004, very few others have been able to replicate, or even get near, that success rate with the same strategy. Gray and Carlisle suggest that part of the problem is that the Magic Formula systematically overpays for quality. In other words, taking a whole-of-market view and simply adding together the ranks for quality and value can actually land you with a pricey portfolio. Instead, they reckon it’s actually better to take the cheapest 20% of the market and then rank that set for quality.
Start with cheap… then look for quality
So how can you do it? Well, Stockopedia’s recent homepage facelift came with some handy new StockRank screening recipes that mean you can filter the market for companies that score highly on different rank combinations, including quality, value, momentum and growth. In this case, we looked to see which stocks were coming up on small cap quality and value screen, which looks for the cheapest 20% of shares with a market cap of between £50 and £350 million with the best relative quality credentials.
Under the bonnet, this screen ranks shares for cheapness based…
