When markets sell off in a big way, even the most liquid blue-chip stocks can fall dramatically. Funds that need to raise cash for redemptions have little choice but to unload even the most fundamentally sound stocks. To be sure, that creates opportunity for other investors to scoop up these stocks at bargain prices. But trying to catch a falling knife is always risky, especially for investors who don’t have huge amounts of cash to average down as prices keep falling.

For investors in small cap stocks, however, the sort of volatility exhibited by heavyweight stocks recently is par for the course. With limited analyst coverage and a narrower investor following, small cap stocks tend to be relatively illiquid. Consequently, they can be extremely volatile even when the broad market is holding steady. Yet, as with the recent volatility in big caps stocks, that creates opportunity to find bargains. The higher volatility in this sector means there is a greater chance of finding mispriced stocks.

How does one decide when a stock is cheap enough to buy? Clearly, much depends on the stock itself. Shares in a company with a resilient business and undervalued assets stand a better chance of quickly rebounding and then climbing steadily higher after a big sell-off.

Renfred Tay, an analyst at KGI Fraser Securities, explained his strategy for finding good stocks in the small cap space in a recent issue of The Edge Singapore (Issue 691, Aug 24). The most important thing, he said, is that the company has a business that is easy to understand. “I want to see if there is a clear-cut and simple investment thesis to be made. The simpler the better,” he told The Edge Singapore. “If its investment merits can be hotly debated or are too complicated, then it’s probably a no-go for me.”

Among the characteristics of a winning stock, according to Tay, are identifiable and continuing earnings drivers, undervalued assets that have the potential of being revalued, a substantial amount of net cash and growing dividend payouts. In addition, it’s important to identify performance catalysts that will drive the stock, he adds. After all, lots of undervalued stocks remain undervalued if nothing changes at the company.

Tay went on to name four stocks that he believes will perform well. They were AP Oil International, China Sunsine Chemical Holdings, Innovalues and Valuetronics Holdings. The companies are in varied businesses, and have very different micro stories. However, they all have solid balance sheets, and their shares trade at less than 10 times earnings.

Interestingly, all four stocks also have relatively high Fundamental Scores and Valuation Scores at www.theedgemarkets.com/sg. The Fundamental Score rates a stock on the basis of its six metrics of profitability and financial strength. The metrics are return on equity (ROE), net margin, current ratio, cash ratio, gearing and interest cover. The Fundamental Score ranges for zero to three, with three indicating very strong fundamentals.

Similarly, the Valuation Score rates stocks on the basis of four valuation metrics. They are the P/E-to-growth ratio, the P/E-to-ROE ratio, price-to-NAV ratio and dividend yield. The Valuation Score ranges from zero to three, with three indicating that the stock is very attractively priced.

Experienced investors will know that the usefulness of specific fundamental and valuation metrics varies with the kind of business the company is in. Different investors might also simply prefer to rely on some metrics more than others. So, the weightings of each of the metrics that determine the Fundamental and Valuation Scores at www.theedgemarkets.com/sg can be manually reconfigured.

Here’s how Tay’s stock recommendations stack up: AP Oil (Fundamental: 2.8; Valuation: 2.4); China Sunsine (Fundamental: 2.1; Valuation: 3.0); Innovalues (Fundamental: 3.0; Valuation: 2.1); Valuetronics (Fundamental: 2.1; Valuation: 1.8).

So, what other small cap stocks have relatively high Fundamental and Valuation Scores? A few that we found were Micro-Mechanics Holdings (Fundamental: 3.0; Valuation: 2.1); Noel Gifts International (Fundamental: 3.0; Valuation: 1.8) and Penguin International (Fundamental: 2.3; Valuation: 3.0).

Of course, fundamental and valuation metrics aren’t the only things that investors should consider when sizing up a stock. They should also consider what’s happening at the company, and whether its business is heading in the right direction. And, as it happens, Noel Gifts and Penguin International are subjects of stories in the latest issue of The Edge Singapore (Issue 694, Sept 14). Micro-Mechanics was the subject a story in the previous issue of the paper (Issue 693, Sept 7).

As global markets continue gyrating wildly in the weeks ahead, opportunities to pick up fundamentally sound stocks at bargain prices could emerge. While the risks seem high, it’s potentially a great time to get interested in the market. 

Download the full issue here: http://goo.gl/cn46Mu