O'Shaughnessy's Tiny Titans Screen: A small-cap value and momentum strategy

In Brief

Tiny Titans is a small/micro-cap strategy developed by O'Shaugnessy in his 2006 book, "Predicting the Markets of Tomorrow". It looks for cheap small caps with upward price momentum.

Background

James O'Shaughnessy is an American investor and the founder and CEO of O'Shaughnessy Asset Management, (OSAM), an asset management firm headquartered in Stamford, Connecticut. O'Shaughnessy wrote the seminal 1996 book "What Works on Wall Street” where he set out his renowned Cornerstone Growth and Cornerstone Value strategies, which we've discussed and modelled elsewhere. 

In his earlier work, O’Shaughnessy avoided micro cap strategies but, in his 2006 book, "Predicting the Markets of Tomorrow", he argues that markets move in 20 year cycles and, because of the principle of mean reversion, the next 20 years is most likely to favour small-caps: "The best returns will likely come from the stocks of small-size companies, mid-size companies, large company value stocks, and shorter duration, intermediate-term bonds". 

He also noted that tiny micro-cap stocks have several unique features that make them ideal for aggressive investors:

1. As with small-cap stocks, it’s virtually impossible for Wall Street analysts to give adequate coverage to micro-cap stocks. It’s not worth their time to do deep research on such a large number of tiny-cap stocks, which makes the market imperfect and with considerable potential upside.
2. Second, micro-cap stocks have lower correlations with other capitalization categories. While small stocks in general have an average correlation with the S&P 500 of 0.74 between 1952 and 2004, micro-caps have an even lower correlation of 0.66. This means that they offer diversification benefits.
3. Finally, micro-caps are extremely volatile and best suited to investors willing to accept dramatic ups and downs in their portfolios.

Criteria

Tiny Titans is the most "aggressive" of his small-cap strategies. The criteria are quite simple:

• Market cap of $25 to $250 million (£15 - £150m assumed in a UK context)
• Price to sales below 1
• Minimum liquidity - When describing the universe of liquid stocks, O’Shaughnessy puts the minimum at $500,000 traded per day. 
• From this list, the idea is to take the top 25 sorted by 12 month price appreciation and equally weight them.

Does it work?

From 1951 through 2004, the strategy had a real (i.e. above inflation) average annual  return of almost 19%. turning one dollar invested in 1951 into $9,734.85 by the end of 2004. In contrast, a small-cap index offered a real average annual return of 10.44% per year over the same period. The downside to that kind of performance is massive volatility.  The standard deviation from the average return (24.6% when not adjusted for inflation) is about 39%.  This means 95% of the time the returns were between a loss of 53% and a gain of 102%. As the author notes:

 Yes, the strategy has offered awesome returns over the last fifty- three years, but you must ask yourself if you could realistically stomach a loss of more than half of the value of your portfolio in a single year".

Not a strategy for widows and orphans then!

O´Shaugnessy found that quarterly rebalancing instead of yearly rebalancing enhances the portfolio performance. But rebalancing too often, say every month, has a detrimental effect to performance because of the higher trading fee costs and slippage.

How can I run this Screen? 

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From the Source

O'Shaugnessy's most recent book, “Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years” (2006), is available on Amazon. The 2005 version of "What works on Wall Street" is available on Amazon. It's also worth referring to his “What Works on Wall Street” website.  

Further Reading:

• AAII presentation on Tiny Titans
• Tiny Titan Portfolio for March