11 cheap small caps

The question of what ratios are best for identifying value is a fraught one, so we've applied something of a shot-gun approach with this week's screen. We are searching for shares that appear cheap based on one or more of five different measures (see box). This is based on the approach used by famed US contrarian investor David Dreman.

There is one very noteworthy difference between our screen and Mr Dreman's method. Mr Dreman believes investors should focus on larger companies when looking for value shares, as they are less risky. Our small cap value screen by contrast embraces the added risk but also the added potential for higher returns from small caps by only looking at constituents of the FTSE Small Cap and Aim indices. We are interested in are the cheapest 25 per cent of shares based on any of our five valuation measures. We've used the ratio that Mr Dreman suggests plus our own genuine-value ratio, which we first screen with two weeks ago. When valuation measures were not possible to calculate due to inadequate data, or came in at zero or below, we eliminated these stocks before choosing our cheapest 25 per cent.

Stocks that appear to be cheap then have to prove their mettle by passing the following series of tests.

■ Underlying EPS from the most recent half-year period (EPS H0) plus EPS from the half year before that (EPS H-1) must be greater EPS H-1 plus EPS H-2.

■ Forecast EPS must be positive. For shares qualifying based on a low GV ratio, we have eliminated any companies with forecast growth of over 50 per cent as such growth rates can well prove unsustainable even for fast-growing smaller companies.

■ The current ratio (net current assets/net current liabilities) must be greater than one, which suggests a company is in a good position to pay its upcoming bills.

■ Gearing (net debt/net asset value) must be less than 75 per cent.

■ The company must pass at least one of Mr Dreman's two quality tests of having operating margins better than 8 per cent or return on equity of more than 10 per cent. For companies qualifying based on our GV ratio we've insisted they pass both tests.

■ Dividend cover of than 1.5 times or more, or above the three year average - Laura Ashley passes the latter of these tests despite having a cover ratio of just one as it was paying uncovered dividends in the previous two years.

■ For low PE and low PCF stocks we've also applied Mr Dreman's test that DY should be above average (median average in the case of our screen), which reflects the importance he attaches to yield in achieving returns.

11 CHEAP SMALL CAPS

Eight of the stocks that have met our screen's criteria have IC ratings and of those seven (all except for Avon Rubber) are buys. Momentum has recently been a powerful force in determining performance, so we have taken a closer look at the five stocks with the highest three-month momentum below. We've also put together some fulsome valuation-ratio tables for the other six stocks passing our screen.

Globo (GBO)

Software group Globo underwent something of a transformation in 2012. It managed to divest its Greek software operation, which had been a concern to investors, while at the same time it gained traction in international markets with its mobile software products. The most noteworthy recent international development was its push into the US through an acquisition, and the group recently announced a distribution deal with Ingram Micro in North America. It's the group's business software that is generating most excitement in the City at the moment. The software allows a company's employees to access business-related programs and data that is stored in a secure remote location. This taps into a trend known in the IT industry known as 'Bring Your Own Device', whereby information is accessed through many different types of computers - from smartphones to laptops and desktops. If the group's software continues to be taken up then it offers very significant growth potential. The exciting developments have been reflected by the shares recent promotion into the FTSE Aim 100 index.

Source: S&P Capital IQ

Last IC view: Buy, 24p, 24 Sep 2012

St Ives (SIV)

The recent momentum in St Ives' shares could mark an inflexion point in the market's perception of the company as it moves from being a cyclical play in a moribund industry (printing) to a marketing services group with growth prospects. The company's first-half results revealed that marketing services revenue had risen by 36 per cent and the division's contribution to profits had swelled from 20 per cent a year earlier to 31 per cent. Broker Numis predicts that this will be up to 50 per cent of sales in two years' time. The acquisition of digital marketing business Amaze for £15.3m this month will aid this growth as it adds an important strand to the marketing operation. Meanwhile, the printing business looks in improved shape following its exit from lower-margin markets. Ongoing cost savings and efficiency improvements are expected to underpin performance in what is a tough market. Management's confidence in prospects have been underlined by a mighty 14 per cent hike in the half-year dividend, adding to the income allure that helped the shares qualify for this screen.

Last IC view: Buy, 136p, 12 Mar 2013

Plastics Capital (PLA)

Plastics Capital, which describes itself as a plastics-manufacturing consolidator focused on niche markets, is the smallest company making it through our screen. While some of its end markets are cyclical - Europe has been a particular drag recently - the company is using innovation to create sales in new markets for plastics with a product aimed at replacing metal ball bearings. So, despite weakness in some areas, performance is being supported by new business wins and there are hopes that significant car industry contracts could soon come through. Indeed, first-half revenues came in flat despite a 30 per cent drop in its more commoditised European product sales. The company has been investing in expanding into growing regions and is setting up a factory in China to win more work in the region. And despite cyclical headwinds, the compound annual growth rate of underlying EPS over the last four years has been 10 per cent. Cash generation is also good and, despite the investments made by the business, net debt has dropped by £10m over the three years to £8.6m at the half-year stage. Our GV ratio, which looks back at the last full-year dividend, also does not take full account of the income attractions of the stock. The half-year dividend was doubled to 0.66p and broker First Columbus predicts the full-year payment will double to 2p, followed by an increase to 3p in 2014 then 4p - equivalent to a 4.9 per cent yield - in 2015.

Last IC view: None

Avon Rubber (AVON)

While Avon Rubber's shares have re-rated over recent months, putting them on a PE rating that does little to stand out in its sector, our GV ratio suggests there could be more value in the shares than meets the eye based on forecast EPS growth and the company's low net debt. That said, not all analysts are as bullish as the EPS growth predictions in our table suggests, with some forecasting low double-digit EPS growth rather than the 26 per cent consensus from our data trawl. Avon designs, develops and manufactures products for the respiratory protection and defence sectors, which account for about 70 per cent of its sales, and the dairy industry. As such, fears about US sequestration and the tough consumer environment are issues. But the strong order book reported by the group when it issued a trading update last month suggests it is handling the challenges well. And what is perhaps of more interest to the market is the investment the group has been making in product development over recent years. This has already started to boost growth but analysts hope the real boon should begin to become clearer in the second half of the year.

Last IC view: Hold, 425p, 18 Feb 2013

XP Power (XPP)

XP Power had a rather disappointing 2012 with revenues falling 9 per cent, but the performance hides the very encouraging progress made over recent years transforming the business into a high-margin, long-term growth play. XP has gone from essentially being a distributor of products to a designer and manufacturer of its own power conversion solutions. Indeed, in 2012, 62 per cent of revenues came from its own-designed products. While tough conditions in the group's end markets led to the revenue decline last year, the group is considered to have a number of market leading products and analysts expect XP to start to drive growth by winning market share. The emergence of any cyclical tailwind would be a big plus as the group has high levels of fixed cost so extra revenue tends to have a disproportionately large impact on profits. Strong cash generation and low gearing also means the group is well-placed to continue its progressive dividend policy following an 11 per cent increase in the 2012 full-year payment. Broker Investec forecasts a 4.9 per cent yield this year, rising to 5.4 per cent in 2014.

Last IC view: Buy, 1,080p, 23 Feb 2013

Charles Taylor (CTR)

Last IC view: Buy, 175p, 6 Sep 2012

Laura Ashley (ALY)

Last IC view: Buy, 24.3p, 12 Sep 2012

Circle Oil (COP)

Last IC view: Buy, 20p, 5 Sep 2012

S&U (SUS)

Last IC view: Buy, 854p, 26 Sep 2012

Pennant International (PEN)

Last IC view: None

Unitech Corporate Parks (UCP)

Last IC view: None