Tiny Titans Strategy: Smaller Stocks, Bigger Gains

The O’Shaughnessy Tiny Titans stock-picking strategy focuses on low-price micro-cap stocks that meet criteria for value, size and momentum factors. Small-cap stocks normally do well during economic recoveries.

There is a feeling of optimism among investors driven by positive vaccine trials and improving economic expectations, especially among smaller firms. Shares of small U.S. companies have soared past larger firms for 2020 after last month’s rally continued into December. According to data reported by the Wall Street Journal, the gain for the small-cap Russell 2000 index for the year surpassed that of the mid- and large-cap S&P 500 index early last week for the first time in 2020. The small-cap index is up 14.6% this year through December 11, compared with a gain of 13.4% for the mid- and large-cap index. AAII’s O’Shaughnessy Tiny Titans approach is up 25.4% year-to-date through November 30.

For the patient investor with the ability to withstand the higher short-term volatility and risk of micro-cap stocks, there is the potential for strong long-term returns. As of November 30, AAII’s O’Shaughnessy Tiny Titans screening model has an annual gain since inception (1998) of 22.2%, versus 7.9% for the S&P SmallCap 600 index in the same period.

Investing in Micro-Cap Companies Using the O’Shaughnessy Tiny Titans Screen

AAII tracks several screens from James O’Shaughnessy, the founder and chairman of O’Shaughnessy Asset Management LLC, an asset management firm headquartered in Stamford, Connecticut. The O’Shaughnessy screens that AAII has developed are based on the strategies outlined in his books What Works on Wall Street: A Guide to the Best-Performing Investment Strategies of All Time, (3rd Edition, 2005, McGraw-Hill) and Predicting the Markets of Tomorrow: A Contrarian Investment Strategy for the Next Twenty Years, (2006, Penguin Group). It is from the latter book that the concept of the Tiny Titans approach was derived.

The Tiny Titans approach focuses on low-price micro-cap stocks. Much research has been done regarding the success of investing in this market-cap category. AAII’s Model Shadow Stock Portfolio is based on a study that showed that small- and micro-cap stocks tend to outperform the overall market over long periods.

O’Shaughnessy believes the reason for this outperformance is that few analysts follow these small stocks. Also, many institutional investors and mutual funds cannot trade these stocks without moving the price due to the relatively small number of outstanding shares. This leaves room for surprises, which can lead to a performance “pop.” O’Shaughnessy also says that micro-cap stocks have a low correlation with the overall stock market, making them a potential hedge in a portfolio of larger-cap stocks.

Low Price-to-Sales Ratio & Strong Price Strength Relative to the Market

AAII’s version of O’Shaughnessy’s Tiny Titans stock screen consists of very few criteria. First, all foreign stocks and over-the-counter stocks are eliminated. Next, a stock’s market capitalization must be between $25 million and $250 million. For the universe of exchange-listed (non-OTC) stocks as of the end of November, the median market cap was $1,002.3 million and the average market cap was $11,020.3 million.

After filtering out the larger-capitalization stocks, the Tiny Titans screen looks for stocks with price-to-sales ratios of less than 1.0. This ratio compares the current stock price to the sales of a company. O’Shaughnessy uses this as a proxy for “cheapness,” as opposed to a price-earnings ratio. He reasons that all viable companies have sales, and sales are harder to manipulate than earnings. In his book What Works on Wall Street, O’Shaughnessy found that stocks with low price-to-sales ratios produced higher returns.

Finally, O’Shaughnessy thinks investors should hold 25 stocks in this micro-cap portfolio to diversify the risk that goes along with holding such volatile stocks. He narrowed the list to the 25 stocks with the highest 52-week relative strength as compared to the S&P 500. So, on a monthly basis, AAII tracks only those 25 companies with the highest 52-week relative strength. As of the end of November, the 25 companies passing the O’Shaughnessy Tiny Titans strategy ranked in the top 89% of all stocks regarding 52-week relative price strength.

For a stock investment strategy to be useful, it must be investable. That means a quantitative approach needs to generate a large enough universe of passing companies on which to perform additional due diligence to identify investment candidates. Since the O’Shaughnessy Tiny Titans screen looks for the 25 companies with the highest price strength over the last year after applying the market cap and value filters, there are always companies passing. Keep in mind, however, that there may be periods when the companies with the “best” price strength may still be down over the last 52 weeks. The Tiny Titans methodology looks for those companies with the strongest price performance, but not necessarily a positive price change.

The average monthly price returns in 2020 for the stocks comprising the O’Shaughnessy Tiny Titans screen’s strategy ranged from a loss of 35.9% in March to a gain of 26.3% in April.

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The stocks meeting the criteria of the approach do not represent a “recommended” or “buy” list. It is important to perform due diligence.

If you want an edge throughout this market volatility, become an AAII member.