10 fast-growing small-caps for fearless traders

After the volatility that rippled through the market in February and March, equity prices enjoyed a stunning rise in April. The bounce was particularly noticeable in small company indices like the AIM All-Share and the FTSE Small Cap.

This suggests that investors were once again warming to the risks and potential payoffs that can be found in small-cap stocks.

Source: interactive investor            Past performance is not a guide to future performance

Over the past couple of weeks, we've looked at how share prices can surge on company earnings surprises and upgraded analyst forecasts. On their own, these events have been shown to cause momentum in share prices over the medium term. This type of momentum is heavily influenced by investor behaviour, and it's been shown to be one of the most powerful return drivers in the stockmarket.

But how can momentum be integrated into the kind of strategy that would look for fast growth in small company shares? One answer lies in the approach used by the veteran US fund manager, Richard Driehaus.

Driehaus is a classic "buy high, sell higher" momentum investor. He once explained: "One market paradigm that I take exception to is: Buy low and sell high. I believe far more money is made by buying high and selling at even higher prices." Driehaus played a major role in introducing momentum to mainstream investing - and he still does it through his fund firm, Driehaus Capital Management.

In essence, the Driehaus strategy looks for fast earnings growth in small companies with low analyst coverage but with rising share prices. So, in many ways it's a typical trader's strategy.

Indeed, he pinpoints long-term earnings growth as the main driver of share price movement. So central to his strategy is a focus on finding growth companies with rising rates of earnings per share and then figuring out which of them are likely to keep on delivering.

Doing this means that this strategy hinges on the academic evidence that trends in both share prices and earnings tend to persist. In the same way, companies with rising profits that are beating market expectations tend to keep beating those expectations.

For these reasons, Driehaus takes the view that rising prices tend to be more important than valuations, or even above-average debt, as long their earnings growth looks assured. In terms of earnings, he looks for a track record of growth but, again, wants to find companies that are beating analyst expectations and delivering positive earnings 'surprises'.

A focus on price and earnings momentum

Stockopedia's own modelling of a Driehaus inspired strategy has delivered a 22% gain over the past year, with a sharp increase of 11% during April. This week we've recreated the Driehaus approach with a few of his favoured measures. These companies have all been seeing impressive earnings growth and strong support for their shares over the past year.

Source: Stockopedia                          Past performance is not a guide to future performance

The Driehaus screening approach picks up some of the most exciting, fastest-moving stocks in the market. Companies like Alliance Pharma, Bioventix, Elecosoft, Premier Technical Services and Sanderson are all small companies that have seen rapid re-ratings on fast-paced earnings growth.

The catch, of course, is that small, fast-growing companies are prone to sudden setbacks, and that's exactly what happened to lighting specialist Luceco, which is also on the list. Last year it issued a profit warning on margin weakness that was not picked up earlier because of a glitch in its financial controls. The share price was hammered, but signs of recovery since mean that the company still passes the Driehaus rules. It's a reminder of how careful investors need to be with smaller companies.

Despite the risks, the combination of fast earnings growth in positive momentum stocks that are beating expectations is naturally attractive to investors looking for rapid price gains. These types of companies are capable of delivering impressive returns - but the risks should be taken seriously.

Strong momentum can collapse suddenly when the growth in smaller companies either slows down or they hit problems. But in the current climate, where small-cap stocks are enjoying favourable attention, this approach to finding growth stocks on the move could be worth a closer look.

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