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Shares Race Explained22.06.2016

This is a hypothetical $100,000 investment with $10,000 in 10 companies. Last week, Under the Radar came 3rd with a total of $104,459 at the end of the 4 week race.

Many subscribers ask how we come to choose our shares for each Sunday’s Money Shares Race in the paper.

Believe you me, it is no great mystery. It is simply based on using our universe of small cap stocks and screening them on the basis of momentum. These stocks are part of our universe because we have researched them from a fundamental perspective - analyzing their sales growth, profit margins, balance sheet and valuation. We also speak regularly to management, so we can say we know these companies well.

But timing is also a big factor in investing. For this reason, high powered fund managers take advantage of different “momentum” factors when deciding when to enter and exit a stock.

The momentum phenomenon has been shown to work across geographies and for different periods of time. It is one of the most robust phenomena in terms of asset pricing that there is.

Its basis is that stocks that have moved up recently, will continue to move up, while stocks that perform poorly will continue to go south.

Why don't you just use momentum when you buy shares?
Having said that, the problem with solely basing decisions to buy and sell on price momentum is that there is a high turnover factor, which means the costs often outweigh the benefits.

For this strategy to be successful you would need a high volume of trades, which means a great deal of buying and selling, which costs money in terms of stamp duty and brokerage. This would erode your returns (it would probably end up costing you money).

One way we mitigate this, is to include a third risk factor, which penalises stocks that are considered to have volatile returns, and rewards companies that have delivered steady gains for investors.

It must be stressed that Momentum doesn't work in the long term, and some of the biggest blow ups in history have occurred through its determined use. Momentum works until it doesn't. Do you remember Long Term Capital Management, which dusted US$4bn in 1998?

Radar’s Quantitative Analysis Explained

We take our universe of 90 plus Small Cap companies that Under the Radar has researched from fundamental standpoint, and rank these companies’ performance based on three objective factors.

Two are price momentum factor – relative strength, and price momentum, and one is a risk factor, measuring a stock’s volatility (its movement up and down).

These are the best three factors for Small Caps, which aren’t covered by many (if any) broking analysts and don’t have consensus earnings estimates. It has also been shown that price momentum is more powerful for the prediction of prices for Small Caps, versus their bigger counter-parts.

1ST MOMENTUM FACTOR
The first momentum factor is called Relative Strength (RSI).
It identifies stocks that have a high frequency of daily upward moves. It looks that the ratio of upward moves and the size of those moves relative to downward moves of that stock’s price.

2ND MOMENTUM FACTOR
The second, the price momentum indicator
is more straight forward and simply identifies stocks that have had strong price movements in either direction (the higher the ranking, the more positive the stock movement).

RISK FACTOR
We measure our Small Cap companies’ risk
by recording each stock’s volatility to reward companies that have delivered steady returns to investors.

What happens when Radar’s stocks go up and down?

If a stock has been travelling well for a while, and goes up 25 per cent yesterday, it will rank well on RSI and might go well on price momentum, subject to its past, but will be penalised on the basis of return volatility.

In contrast, if another stock goes up 25 per cent over a month through smaller gains, that stock will get rewarded relative to the stock whose move was in one day.

The indicator doesn’t like stocks gapping up or gapping down (going up or down very quickly) and as a result, it helps to dampen the level of turnover (buying and selling) in the strategy.  

The end result is a list of Radar’s Small Caps, the top ranking of which is considered by Radar’s Quantitative Investor to be a stock that has been going up and is a good bet to continue going up in the short-term.    

In his words: “I’m using a utility-based model which rewards stocks with high momentum, and low risk.”    

What’s in this week’s issue?

We talk about Gold as a hedge
With the potential Brexit in the wings, we discuss how you can position your portfolio to hedge your bets. That’s right, we talk gold. We’ve long been advocates of have a percentage of your portfolio invested in the yellow metal and we speak to a number of sector experts and look at some of their, and our, favourites.

New Stock: Fintech with great growth potential
We initiate coverage on an Under the Radar fintech Small Cap, that has built its technology and is verging on profitability. We think that its business can generate big profits if its volumes continue to grow, because of its fixed cost base.

We also update several Small Caps, including Ingenia Communities (INA) and Speciality Fashion (SFH).

There is always a lot to look forward to, but rarely has there been so much uncertainty in investment markets. You need to be on top of it to know how to position your portfolio.

Richard Hemming
Small Cap share expert and Under the Radar Editor


About the Author

Caroline Mark

Caroline is the publisher of Under the Radar Report. She has a diverse background, from producing financial publications, to fundraising and marketing.

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