How do you turn 58,200 stocks into one investment?

• How many stocks are in the world?
• What is a filter and how do you use it?
• 72% in 11 months from cheap shoes

On any particular day, there’s around 2,000 stocks available to trade on the London Stock Exchange. Same goes for the Australian Securities Exchange, it’s about 2,000. The Nasdaq Stock Market has “over” 2,500 and the New York Stock Exchange has about 2,800.

That’s just some of the markets available to trade for investors in the world. There are, of course, markets in Europe, Asia, the Middle East, everywhere.

In fact, the World Federation of Exchanges (an industry group for stock exchanges and clearing houses) estimates that at the end of Q1 2022, there were around 58,200 publicly listed companies trading on stock markets globally.

58,200 doesn’t sound like a lot to choose from, considering the billions of people living in the world and the trillions in wealth that global stock markets contain.

However, let me put it to you this way…

If you were to research just one company of that 58,200 per day, it would take you 159 and a half years to research them all. And just to make that task even more challenging, new stocks come to the markets every day and existing stocks get regularly delisted from the markets too.

As an example, on the US markets alone, over 170 stocks were delisted from the market between 2020 and 2021. Whereas you’ll find anywhere from 140 to 300 new stocks IPO and start trading on the US markets per year. And that’s just the US.

This happens on every market in the world, which means that the goals are always shifting. It also means that you’ll never run out of companies to look at and find in the market.

However, if it takes over 159 years to research every listed company in the world, how the heck are you supposed to decide to invest in just one?

How do you narrow down 58,200 to 1? Well, that’s what we’re looking at today: taking a wide funnel of opportunities, filtering them down and then deciding on what is the best small-cap stock to invest in at any given time.

What is a small cap?

The first thing to know is that of the 58,200 investable public companies, many of them aren’t small caps. But to figure out what a small cap is, we must define it first.

There is no set parameter of what a small cap might be. Some say it must have a market value under £1 billion, some suggest under £100 million. I think the best way to look at small caps is to consider two key elements.

First, decide what market you’re looking at.

Do you want to find small caps in just the UK? Or do you want to look at them in other markets, like the US or Australia?

Whichever market you decide on, only then do you start to filter your stocks by market cap.

For example, in the UK I would suggest that small caps are those with a market capitalisation under £300 million, but more than £25 million. Right away that immediately narrows down the fishpond. That’s about 650 companies on the London Stock Exchange.

However, in Australia, I would look at small caps from around $500 million to about $75 million. That leaves you with the same kind of number as in the UK.

In the US, well, small caps on the Nasdaq might be anything under $1 billion and over $100 million. Again, here you’re cutting down thousands to a few hundred.

In Europe, it’s more like between €400 million and €50 million.

I believe you need to be flexible depending on your market. You also need to factor in that a $100 million company in Australia is only a £55 million company in the UK when you apply currency conversions.

The US market is also astronomically bigger, with by-nature larger companies, in a bigger market. They tend to be bigger by market cap, which is also where you find most of the mega-cap stocks in the world and larger mid-caps.

Also consider that the composition of each market is different. The UK is renowned for financials; Australia is dominated by mining; and the Nasdaq, by design, is tech heavy. This means that you also need to consider what kind of small caps you’re looking for.

And that’s where the second part of the equation comes into play.

When you’re figuring out what market you’re going hunting in, you’re also thinking what you want.

That could be a small-cap income play, it could be a small-cap growth play – or it could be that rarefied air of a growth company that delivers income and hasn’t seen its stock price decimated!

What a lot of people don’t realise is that from experience, small caps tend to be more growth focused. There’s loads around the world that are profitable, income (dividend) paying and yet can still deliver capital growth over time.

A trap you need to ensure you avoid, however, is hunting for income at the expense of capital value. Dividend paying is great, and a company might look like it’s got a high dividend yield, but that’s always relevant to market cap.

For example, a $100 million small cap might be profitable and have a 10% dividend yield. On the face of it, that’s a wonderful dividend yield. But then you realise that a year ago the stock was worth $300 million. So, the it might appear to be profitable this year and paying a dividend, and you might get a 10% yield at current prices, but year on year you’ve also lost 66% of the capital value.

The reasons for this could be due to an asset sale, a special dividend or restructuring from a previous year that’s cratered the stock price but now added profit back into the cash flows.

Whatever the case, it gives some reason to take a closer look when something doesn’t quite match up.

It’s all about the quality of your filters

You’ll notice here that I’ve mentioned several factors relating to small caps.

Market, market capitalisation, stock price, dividends, dividend yield, profits, industries and cash flows. These are all elements that you can use to help filter down what you’re looking at.

When it comes to figuring out how to turn 58,200 stocks into one investment, these are some of the things worth considering.

Again, using the UK market as an example, if I’ve filtered the choice down to 650-odd companies, then how do I get to one from there?

Well, you might want to try to find a company with a market value of between £50 million and £100 million that’s profitable (net income) on the London Stock Exchange.

If I run that filter using a freely available tool, like Yahoo Finance, I’m left with 65 stocks to choose from. Suddenly, 99 stocks are a lot more realistic to look at.

Some of the stocks that fall into that filter are Shoe Zone, HSS Hire Group, City Pub Group, Belvoir Group, Naked Wines and The Character Group.

Those companies are in the sectors of shoes, tools and equipment hire, hospitality, property and mortgage franchises, wine retailing, and toys and games. I might be able to simply discount some of these companies straight away just because they’re not the kind of companies that fits my wider macro views or investment ideas.

So I might not bother with HSS and City Pub Group, for example. I also see Topps Tiles in those 65, so I cast that one aside for now. There’s a couple investment funds in there too which is not what I’m looking for, and so on.

Quickly, that 65 becomes 30 or less. And that’s when you really get to work.

Getting to this stage is relatively quick if you have some experience in filtering stocks and you have a loose idea as to what you’re after.

Cheap shoes and “cozzie livs”

As I said yesterday, knowing what you’re looking for doesn’t have to be obvious. To be honest, I’d probably look through all 65 of those companies one by one, because I want the next baby formula boom.

I want the small cap that’s got something under the hood that no one else has and that the market has overlooked. Like Shoe Zone.

Shoes. Cheap shoes. Seems bonkers really. But think about it. We are currently in the midst of “cozzie livs”. That’s what I keep hearing in public when people are talking about the “cost of living crisis” in the UK.

Now when people start calling it “cozzie livs”, you know something is out of kilter. Then you hear that a company like Nike is carrying huge overstock because there’s currently a shift away from premium footwear.

But at the same time, people need shoes. So if they’re not going to pay top dollar for them, amid “cozzy livs”, then where are they going to get them from?

I reckon a place like Shoe Zone.

That’s probably why in the last year, Shoe Zone has seen a bump in revenues, a bump in gross profits, smartly kept costs under control and seen a big bump to net profits.

That’s a pretty good explainer as to why its stock price has gone from 145Gbp in August 2022 to 250Gbp just last week. A 72% jump in just under one year for Shoe Zone?

That’s the kind of small cap you love to have and tell your friends about. The one that the market overlooks until it’s jumped 72%. Cheap shoes in a “cozzy livs” is the investment idea. Bonkers as it might sound, it can be that simple.

But you don’t really think I want to find a cheap shoe company during a cost-of-living crisis. You think, in what pockets of the market can I find small-cap stocks that are profitable and have some kind of growth catalyst in there too?

That’s where you filter down through the numbers, find your investable universe, look at 50, 70, 99 stocks, hunting for that trigger, that weirdness, that X-factor that seems a bit bonkers at first, but then when you extrapolate the idea, it seems obvious.

Tomorrow, I’m going to unpick more on that for you.

While today we talked about how to filter and find your investable universe, tomorrow I’m going to explain how I look for and find that X-factor that often goes overlooked. I’ll explain how to formulate an investment idea and apply contrarian thinking in a market that’s very difficult to read and predict, but one that still has great stocks making great returns (like Shoe Zone).

Now, all this you can do yourself – and as you can see, if you’ve got the right approach and understanding of the market, you can find some great companies to invest in. But this is also what we do, all the time. We spend our time deep diving into small-cap stocks all over the world, looking for the best of the best.

Our focus starts right here, at home in the UK. Then, for the more adventurous, a look into the corners of the small-cap markets around the world. Right now, one of our key focuses is on UK small caps that are implementing breakthroughs like artificial intelligence into their companies – it’s one of the many areas of focus we have, and that you can learn about and invest in yourself when you join me at Small Cap Investigator.

Sam Volkering
Editor, Fortune & Freedom