Not every stock selected for the SmallCap Informer performs as expected. While it is always disappointing when companies fail to live up to expectations, it is important to understand how we approach these situations and what goes into decisions to discontinue or carry on with coverage.

Understanding our philosophy on handling underperformance begins with an understanding of our fundamental methodology. The SmallCap Informer employs a long-term, buy-and-hold strategy, operating under the assumption that over the long term, earnings growth always wins out, regardless of short-term market volatility or irrational price movements.

As a result, our initial reaction to stock underperformance or temporary company troubles is most often one of patience. This is challenging since we do not want to fall into the “buy and never sell” trap, and knowing how long to wait before acting to replace an underperformer is often difficult.

Here are a few of the techniques that guide our thinking about how to handle problematic companies.

The 80% Rule

No investor is perfect. The good news is that perfection is not required in order to outpace the market’s returns. BetterInvesting’s “rule of five” states that of every five stocks selected using their Stock Selection Guide methodology, three will perform about as expected, one will outperform, and one will fail, usually due to unforeseen circumstances.

Put another way, fundamental investors can aim for an 80% success rate when selecting stocks. Nonetheless, the 20% of stock picks that don’t work out consume excessive amounts of mental and emotional resources while attempting to discern whether  it is 
appropriate to sell the stock, hold on for now, or perhaps even back up the truck and buy more. 

Mitigating Portfolio Risk through Quality

Downside risk in our stock picks is primarily addressed in the first place by focusing on company quality when selecting the stock, and then maintaining a long-term approach.

Our methodology emphasizes avoiding panic and looking for the best opportunities in any market, always remaining fully invested in stocks. Our belief is that companies with a track record of delivering sales and earnings growth in the past are more likely to successfully navigate difficult times and deliver growth in the future.

Putting Companies “On Probation”

Companies facing uncharacteristic fundamental challenges often get moved to our On Probation list. Companies on this list are usually mathematically in the buy zone on the Stock Selection Guide (SSG), which also means they have the highest total return potential in the coverage list) but there is adequate cause to be hesitant about accumulating shares.

Being placed On Probation signals that coming quarterly reports are expected to bring clarity regarding operations to determine if the stock should remain under coverage or be discontinued. Individuals often hold on to underperformers for too long while awaiting recovery.

The On Probation list serves as a reminder that resident companies on the list should be watched closely for signs of recovery or indicators of future deterioration, either of which can suggest the most prudent course to take.

Subscribers who own or are considering these companies are urged to exercise caution, as upsides may be compelling but downsides may be alarming. New positions should only be taken by subscribers with high risk tolerance and focused portfolio management practices.

For example, long-time holding Skyworks Solutions was moved to the probationary list due to margin slippage and ongoing declines in quarterly growth trends. Boot Barn was placed on probation due to slipping quarterly profit trends and margins, along with company’s guidance for declining earnings. When fundamentals failed to recover within a couple of quarters for these companies, coverage was discontinued.

The Probation approach brings other benefits to portfolio management. Besides keeping companies in the forefront while awaiting confirmation or refutation of trends, it also accustoms investors to the idea of executing the sell decision. If another company is discovered that presents a compelling case for being added to the portfolio, companies that are on probation can be a first source of cash with which to make the trade. 

Sell Methodology and Criteria

Pruning losers is a key part of portfolio management, so a sale is deemed prudent when fundamentals deteriorate and total return objectives come under fire.

Specific fundamental reasons for discontinuation and sale include the following four rationales:

1. Fundamental Deterioration that Obscures the Future: When prospects become murky, recovery seems too far off, or the business mix changes negatively, it is usually better to sell rather than hold. For instance, CoreCard was sold due to great uncertainty about when it would return to a growth path. ASGN Inc. was sold because its growth deceleration trend (four consecutive quarters of slower growth) was deemed the deciding factor, coupled with a changing business mix.

2. Unproven or High Risk Ventures: Investors may have concerns about how a company can perform in new unproven areas or when its stock faces high downside potential. For example, Canada Goose was discontinued partly because achieving high EPS growth would require success in two new unproven areas.

3. Trend of Declining Fundamentals: Consecutive quarters of slowing or declining sales or EPS growth can often trigger a sale. For example, Silicom was discontinued after profits and earnings slid on a downtrend for three consecutive quarters, and Allient was sold after we observed a significant sales downtrends and insufficient cost management to drive adequate profit growth. Skyworks Solutions was discontinued because it appeared to have entered a cycle where growth was no longer achievable in its core markets, despite its long record of fundamental downtrends.

4. Acquisition or Merger: When a company is acquired, a sale is typically recommended. The advice is often to sell immediately (as in the case for Air Lease, McGrath RentCorp, Perficient, and NV5 Global) for simplicity and the ability to reinvest capital into opportunities with a higher potential rate of return, rather than waiting for the deal to close, though tax implications must be considered.

 Valuation Excesses

A sale is also recommended when the price excessively exceeds traditional valuation metrics, making the downside risk too high. The newsletter generally prefers to hold stocks through periods of overvaluation but recognizes that selling is prudent when a stock reaches “hypervalued” status.

The Valuation Watch feature of the newsletter highlights stocks with potentially excessive downsides relative to upside potential (what I call hypervalued stocks). Stocks meeting these criteria are typically deemed overvalued:

• Projected P/E ratios are greater than 150% of their historical average P/E ratios.
• Reward-to-risk ratios are below 1.0.
• Total return projections are less than the current risk-free return available from short-term bonds or cash (typically around 5% a year).
• Current price is near or above the suggested “sale above” prices.

For these stocks, subscribers may consider the taxable impact of selling and consider using Trailing Stop Loss Orders (TSLOs), typically set at a 6%-12% trailing stop, to protect against sudden reversals.

For example, our current Valuation Watch includes Kadant, with a projected total return struggling to sneak above 2.6% a year and a price well above the sell zone cutoff. Hawkins and Charles River Associates  are also listed on Valuation Watch due to low reward-to-risk ratios and prices above their calculated sell targets.

Conclusion

The SmallCap Informer aims to have its picks in the whole consistently outperform the S&P SmallCap 600 Index. While we acknowledge that returns may not exceed the overall market, its lifetime performance has historically exceeded its target index.

The methodology of letting winners ride and getting rid of underperformers has resulted in the average realized gain from all closed positions coming out about even, but more than two-thirds of sold stocks have underperformed the broader market, since the sell was recommended, suggesting the sell decisions were generally correct.

A useful framework to summarize SCI’s sell decisions is thinking of them as being triggered by either Quality Degradation (fundamentals worsening or future growth becoming murky) or Valuation Excess (price appreciation exceeding rational expectations, leading to unacceptable downside risk).

In this issue of the SmallCap Informer, we return to a real estate investment trust that is performing well fundamentally but that continues to be overlooked due primarily to its small size—the perfect undiscovered opportunity for small-cap stock investors.

Stay the course!

• DOUG GERLACH 

Subscribers can read Doug's complete commentary and the in-depth profile of our recommended small company stock in the current issue of the SmallCap Informer stock newsletter. Not a subscriber? Subscribe to the SmallCap Informer and get monthly small company stock recommendations and updated buy/sell prices for each of the ~40 high-quality small company stocks currently covered in the newsletter.