10 Tiny Titans: cheap small-caps with a record of strong momentum

With its simple set of rules, Jim O’Shaughnessy’s Tiny Titans approach remains a powerful strategy.

One of the difficulties of investing in the stock market’s smallest companies is that good quality research into them is hard to come by. This lack of information is enough to scare many investors off. But for those prepared to look for the clues to potential breakouts, these kinds of shares can be very profitable.

Over the past few months, market volatility has soared as investors wrestle with the implications of an economic tsunami. While the outlook is far from certain, not all stocks have been beaten back, and some are recovering well. A look at the early evidence suggests a number of cheap small-caps with a record of strong momentum are moving fast.

One strategy that specifically looks for shares like this is Jim O’Shaughnessy’s Tiny Titans approach.

O’Shaughnessy is widely respected for his detailed work into the quantitative drivers of stock market returns. Back in 2006, in his book Predicting the Markets of Tomorrow, he set out the case for investing in small-caps with a strong blend of attractive value and strong price momentum.

O’Shaughnessy’s strategy focused on companies that were cheap based on their price-to-sales (PS) ratios (which had to be less than 1.0x). He argued the PS was a harder ratio for management to manipulate than other valuation measures. He then looked for the highest one-year relative price strength to find which of his basket of cheap stocks were beginning to re-rate.

In recent years, O’Shaughnessy’s views on measuring value changed. His research led him to adopt a ‘Trending Value’ strategy that ranks companies against a range of valuation ratios, rather than relying on just one. Even so, Tiny Titans and its simple set of rules continues to be a powerful strategy. 

Stockopedia’s modelling of his approach in the UK has found it to be a consistent market-beater - with an annualised return of 18.9% over the past eight years.

That said, it is important to note that while the performance is impressive, this was never designed as a portfolio-building strategy because the nature of the stocks is so volatile. But it can offer up some interesting ideas. Here are some of the stocks currently passing the rules:

This list is a good example of how some small-cap stocks can deliver very strong outperformance against the market.

These are cheap (based on price-to-sales) shares with strong momentum and you find them across sectors.

Remember that smaller stocks are unpredictable and potentially difficult to trade. In addition, because the main measure of value is the price-to-sales ratio, these sorts of firms may not have any earnings, and they may not have any kind of broker forecasts.

Part of the appeal of this strategy is that it focuses on cheapness rather than chasing popular and highly speculative micro-caps, which can become very expensive.

While investing at the smallest end of the market is risky - particularly at times of heightened uncertainty - O’Shaughnessy’s research showed that it can produce excellent gains for investors who are prepared to do their homework.

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