10 small-cap value stocks showing signs of growth

Stockopedia's Ben Hobson uses an approach called Tiny Titans that blends value with relative strength momentum. It's risky, but the potential rewards are significant.

Value investors know that periods of underperformance are par for the course. Even Warren Buffett's mentor Benjamin Graham recommended buying 'baskets' of up to 30 deep value stocks to diversify some of the risk.

High street fashion retailer French Connection is a case in point. Before the recent news that it is being put up for sale, investors who had been expecting that outcome had to endure years of sideways and downwards price moves, only for the shares to spike up and re-rate in a matter of days. With this kind of stock, it is easy to be right - but far too early.

The retailer's shares have doubled since March and yet French Connection still only trades on 0.42 times sales. Some value investors will have found it hard to stick to their guns but, if the sale completes, they will forget all those sleepless nights and crises of confidence.

How to stop buying early

What if we could forgo all that fretting in exchange for a bit of the upside at the beginning? This is the aim of an approach called Tiny Titans, which blends value with relative strength momentum. This small/micro-cap strategy was set out by the US fund manager James O'Shaughnessy in his 1996 book, What Works on Wall Street.

In restricting its universe of stocks to small-caps and micro-caps (we define this as companies with a market cap between £15 million - £150 million), O'Shaughnessy claims to capture several positive traits that make them suitable for the aggressive investor, namely:

1.    Lack of research. It is not worth analysts' time to look into companies whose fortunes would not move the dial for multi-billion-pound fund managers. These neglected stocks can be mispriced by the market and can have upside potential.

2.    Lack of correlation. Small stocks in general have an average correlation with the S&P 500 of 0.74 between 1952 and 2004, while micro-caps have an even lower correlation of 0.66. Both are useful in diversifying a portfolio.

3.    Volatility. These stocks are 'French Connection' stocks and dramatic ups and downs come with the territory.

The process is simple: filter for companies with market caps of between £15 million and £150 million, a price-to-sales ratio of less than 1, and a share price spread of less than 10%. Take the top 25 companies in terms of 12-month price appreciation and you have your team of Tiny Titans. 

Here are the top 10 in Stockopedia's screen:

Source: Stockopedia       Past performance is not a guide to future performance 

This screen makes a point of digging up companies most people might not have encountered before. Most of them are small today but were much smaller a year ago. 

Take financial services firm Lighthouse, for example - last November the group's market cap was just £23 million but its momentum has seen it double. At the other end of the spectrum we have packaging group Macfarlane, which only just qualifies following the October market sell-off.

The Tiny Titans method isn't a surefire path to successful investing and it is not for the fainthearted. Although it boasts a five-year return of 126.5%, its reliance on momentum means that it's prone to underperforming when market sentiment weakens, so that's a reminder of the risks involved. 

It's not hard to imagine an investor applying the screen over the summer, watching their holdings slide, and then selling out for a loss. However, over the long term, this systematic approach of searching for both value and momentum can yield results with a bit of discipline.

There is no escaping that Tiny Titan stocks bring risk. They are small and growing or recovering and there is no guarantee that their positive momentum will continue. In the search for value, however, this screen serves as a useful reminder of how adding in a momentum indicator can boost results and save waiting time.

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