Margin calls are fueling liquidations across various parts of the market. And safe-haven assets like gold continue to plunge as the dollar roars higher. So, where can people put their money? Let’s focus on the small-cap value that no institutions will uncover.
Small-caps tend to outperform the broader market and their larger rivals for a simple reason. They have a longer runway for growth.
Now, retail investors are heading for the exits in a negative momentum environment like this one. As a result, small-cap stocks have taken quite a hit. As a result, the Russell 2000 – which largely comprises small-cap stocks across the U.S. economy – is in free fall.
But not every small-cap stock is bad. There’s real opportunity when you take the time to assess their true potential in recovery. That pursuit is simple. You want to build positions in companies with solid balance sheets, strong cash flow, low valuations, and steep upside.
Finding Great Value
We start with the Piotroski F and Altman Z scores to get us there. You’ve read my insight on the F and Z score.
Joseph Piotroski taught finance at Stanford and the University of Chicago. He created a nine-point system that rewards each company for meeting a certain criterion on its balance sheet. Metrics include higher return on assets year-over-year, decreasing outstanding shares year-over-year, and lower leverage year-over-year.
We don’t need the company to have a 9 out of 9 on the score with our monthly rotation stocks. We just need at least a 7 on that scale to know that the balance sheet has improved dramatically.
Meanwhile, the Altman Z Score is a weighted average of five metrics to determine a company’s bankruptcy probability. We’re always looking for companies with a score over 2.6. Then comes the valuation.
We want companies trading at a cheap Enterprise Value to Earnings Before Interest and Tax (EV/EBIT) of under 8. That lower figure will make it an attractive takeover target and allow it to correct to other industry rivals over time as investors engage in price discovery.
Now… check this out. This simple strategy, since 2000, has been volatile. But we’ve seen annualized returns of 36.9%. Looking to start a portfolio today? Consider shares of Rex American Resources (REX), Zedge (ZDGE), and A-Mark Precious Metals (AMRK).
Analyzing American Airlines
I had a conversation with a great trader today. We discussed the risks and opportunities in the economy. I’ve been worried about the pending diesel fuel shortage that could drive inflation higher and create massive economic shortages.
But he is worried about jet fuel. And he asked a question that pushed me to dig into the numbers… “Do you think it’s possible that American Airlines goes bankrupt?” Simple answer: Yes. Unless the government bails out the airlines once again.
American Airlines (AAL) has a terrible balance sheet. It has a negative book value, so it’s worth $0 in liquidation. Margins are horrible. Costs are rising. There is a pilot shortage. It gets worse when you consider that travelers might start canceling their plans in 2022 because prices are reaching a tipping point.
I was looking at this, and I honestly think that this could be a company that does go under. But, remember, airlines are notoriously bad at managing cash flow.
Instead of building a rainy day fund, airline executives choose to buy back their stock and reward themselves. Looking out a year to 2023, the $10 put on American Airlines trades at $1.00. It’s worth the bet, given that it’s a cheap trade.
If momentum does turn positive again, I’d lift the put and wait until we have another negative momentum event. People are looking for a bottom on airline stocks right now. The bottom for American Airlines within the next few years… is zero. We’ll dig deeper into airlines tomorrow.