We have written quite a bit over the years about using point and figure relative strength for stock selection. One of the whitepapers that discusses the basics of using RS can be found here. In a lot of the research (including the whitepaper in the link) we use a universe of large capitalization stocks. There really isn’t a good reason for the use of that universe. Generally speaking, it is easier to deal with large caps because the information tends to be cleaner, and people are usually more interested in hearing about companies they know and recognize.
Point and figure relative strength works just as well or better on universes of small capitalization stocks. The small cap universe is incredibly dynamic, and each year there are plenty of big winners and plenty of companies that wind up going out of business. The dispersion of returns is very high, which is very good for a momentum strategy. The micro capitalization universe has stocks in it that are even smaller than the small cap universe. Micro caps are truly the wild, wild west. The other characteristic with micro caps that make it a good universe for relative strength analysis is there is very little analyst coverage on these companies because they are so small. That makes it easier to find undiscovered gems than it is in a larger capitalization universes.
To define a micro cap universe, we took the all of the stocks trading on US exchanges at the end of each calendar year and included everything ranked every company by market capitalization. Stocks ranked from number 2000 through 3500 were included in the universe. That universe essentially includes the bottom half (in terms of market cap) of the Russell 2000 and then another 500 stocks that don’t even qualify for inclusion in the Russell 2000 Index. At each month we ranked every stock in the universe by relative strength versus a micro cap benchmark. If you are unfamiliar with how a point and figure relative strength ranking works you can find an explanation in the paper linked to above. Stocks were placed into one of four baskets at each month end based on point and figure relative strength chart configuration (signals and columns). Each month the baskets were refreshed and all of the stocks in each basket were equally weighted. Equally weighting each stock on a monthly basis would prove to be difficult in actual portfolio management, but we are just trying to get an idea about the power of relative strength in this universe.
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The Universe return listed above is the monthly equal weighted return of all the stocks in the universe. We have included this because most broad market benchmarks are capitalization weighted and do not get the benefit of getting reweighted each month at no cost. The returns of the universe are the best apples-to-apples comparison of how the universe was constructed. The Benchmark return is a blended return of two different indexes: Russell 2000 Total Return and Russell Microcap Total Return. The data on the Russell Microcap index doesn’t go back to the beginning of our test. Before the microcap index was available we used the Russell 2000, and then linked that index performance to the microcap index when the data became available.
The stocks on a point and figure buy signal and in a column of X’s are the strongest stocks. That basket of stocks performs remarkably well with very good volatility characteristics. One thing that appears to be the case in the microcap universe is that relative strength helps find quality companies. There are so many microcap companies that are, for lack of a better term, a hot mess. Quality is extremely important when dealing with such small firms. Most large cap companies are large because they have multiple products, experienced management teams, and defined processes and controls. Sure, large cap companies make mistakes and their stock prices can go down quite a bit, but it is nothing like what goes on in the microcap space. Momentum is very important when looking at very small stocks, and it also helps filter out a lot of the companies with poor quality characteristics.
Momentum works in a number of different markets and across markets. In a universe of very small companies it is no different. Using point and figure relative strength as a filter to focus on the strongest stocks in the universe is a great way to increase your odds of success.
Performance data is the result of hypothetical back-testing. Investors cannot invest directly in an index. Indexes have no fees. Back-tested performance results have certain limitations. Back-testing performance differs from actual performance because it is achieved through retroactive application of an investment methodology designed with the benefit of hindsight. Back-tested performance do not represent the impact of material economic and market factors might have on an investment advisor’s decision making process if the advisor were actually managing client money. Past performance is not indicative of future results. Potential for profits is accompanied by possibility of loss. Neither the information nor any opinion expressed shall constitute an offer to sell or a solicitation or an offer to buy any securities, commodities or exchange traded products. This document does not purport to be complete description of the securities, markets or developments to which reference is made. Performance is inclusive of dividends, but does not include any transaction costs.