Wall Street is Terrified of This Research Paper

A research report being circulated through the financial community right now has both independent traders and hedge fund managers alike scratching their heads, cursing under their breath, and fearing for their lives.

The report goes by the somewhat glib-sounding name of “Size-Matters, If You Control For Junk,” and it distills more than five decades of stock market data into a single, unified conclusion.

The crazy thing is that this report hasn’t even been officially published yet. Only the rough draft has been seen so far, and only by a limited number of people.

But its authors aren’t nearly as lighthearted in their scientific approach as they were in finding the title.

Of the five authors, three are hedge fund managers, and two are business school professors:

Cliff Asness, Andrea Frazzini, and Ronan Israel of AQR Capital, a Greenwich, CT-based hedge fund company; Tobias Moskowitz, a professor at the University of Chicago’s Booth School of Business; and Lasse Pederson at the Copenhagen School of Business in Denmark.

And what was their conclusion?

Well, it was a deceptively simple premise — and one that I’ve been writing about for months now, albeit in a slightly different format (I’ll explain how in a minute).

To put it as succinctly as possible, this unprecedented piece of research found that in order to consistently beat the market, all you have to do is this:

Buy companies that were both small and “high quality” when measured by things like balance-sheet strength, profitability, stability and growth.

It Undermines 75% of the Financial Industry

The stunning thing about this conclusion is how obvious it is to many of us who have been living and trading by this gospel for years.

And also how potentially earth-shattering it is for major financial institutions that create all of their wealth by betting on Fortune 100-caliber firms exclusively.

I don’t want to sound conceited at all, but if that’s how it comes off, it’s because there is no other way to phrase it.

The conclusion of this report confirms and reinforces my theory on microcap trading to the T.

You invest in companies that are small — a policy taken to its purest level when focusing on microcap investing.

You invest in companies that show strength and profitability — which is exactly the effect that screening out companies with poor profit and gross margins will have.

You invest in companies that show high potential for stability and growth — which is exactly what you’re left with when you filter out small companies that either don’t have cash or foolishly pay out profits in dividends instead of reinvesting.

The authors of this report referred to it as “controlling the junk.” I refer to it as “statistical de-risking” (I guess I’m just not as colorful a wordsmith as some of these financial gurus).

But at their core, these concepts speak to the same basic truth: Small companies have bigger growth potential, but that potential needs to be vetted for unnecessary volatility.

Having experimented with this theory for years now, I’ve boiled it down to a four-step process that puts the concept into practice, and with pretty spectacular results:

1. Avoid the Dividends: Earlier-stage companies need to be reinvesting, not doling out profits.
2. Cash Reserves: This implies a healthy, stabilized debt-to-equity ratio, meaning the company has room to operate, execute R&D and marketing campaigns, hire new staff, and buy new equipment. If the company is a body, the cash is the blood. You don’t want an anemic infant.
3. Strong Profit Margins: A good profit margin isn’t essential, but it’s indicative of stability and further growth. Companies with a 5% profit margin are acceptable, but I prefer to see 10% or better.
4. Gross Margins of 50% or Better: This implies that the business model works and will continue to keep the company profitable moving forward.

The Proof

My first two investments following this exact model landed 70% and 40% gains in just a few months — and they both had the same basic traits in common…

Small size, stability, no dividends, solid growth potential.

You can look them up yourself and see how they performed in the second half of last year:

LRAD Corporation (NASDAQ: LRAD) and Aware Inc. (NASDAQ: AWRE).

Of the next three that I picked, two of them also brought back similar returns in less than three months’ time — with one position still open.

But again, I’m not trying to sound conceited here. I didn’t invent this concept — I’m just somebody who quantified how to put it into practice when dealing with microcaps.

The general idea has actually been around for years — long before those three hedge funders and two professors went to work on their research paper.

In fact, stories of how others put this basic trading strategy to use go back at least two decades, and I bet you’ll be shocked when you hear them.

A few weeks ago, I put together my own research report on how statistical de-risking works, why it works, and, of course, a few stories about the people who have used it successfully.

And here’s a little hint: None of the stories in this report are about people who were anything close to professionals when it comes to investing.

They’re just everyday people who were lucky enough to stumble onto a basic concept, either by accident or through raw brainpower.

The report is free and — unlike “Size-Matters, If You Control For Junk,” — finished, and it’s available for you to look at immediately.

Get instant access right here.

Fortune favors the bold,

Alex Koyfman

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His flagship service, Microcap Insider, provides market-beating insights into some of the fastest moving, highest profit-potential companies available for public trading on the U.S. and Canadian exchanges. With more than 5 years of track record to back it up, Microcap Insider is the choice for the growth-minded investor. Alex contributes his thoughts and insights regularly to Energy and Capital. To learn more about Alex, click here.