Small-cap shares have had a storming run over the past 12 months but 'cheap' small caps have had an even more stellar run. The 11 stocks selected by my 'cheap small cap' stock screen last year have returned 44.5 per cent compared with 23.2 per cent from the FTSE Small Cap and 22.4 per cent from the FTSE Aim All-Share (see graph).
The outperformance of the five stocks that were demonstrating the best three-month momentum at the time of last year's screen was even better than the average, notching up a 47 per cent gain. That was despite a relatively poor performance by mobile software company Globo which has been hit by concerns about its accounting and lack of cash generation. All in all, despite the inherent risks associated with small caps, there were few big disappointments with only Laura Ashley (ALY) posting a negative return, and its loss was a manageable 5.9 per cent. And only three stocks in total underperformed the market - Globo and Unitech being the others. The full list of stock performance can be seen in the chart below ordered by strongest to weakest three month momentum at the time of the screen.
| Name | TIDM | Cheap | Total return (20 Mar 2013 - 11 Mar 2014) |
|---|---|---|---|
| Globo | GBO | GV | 17.0% |
| St. Ives | SIV | DY | 51.1% |
| Plastics Capital | PLA | GV | 58.5% |
| Avon Rubber | AVON | GV | 55.0% |
| XP Power | XPP | DY | 53.6% |
| Charles Taylor | CTR | PCF | 54.3% |
| Laura Ashley | ALY | DY | -5.9% |
| Circle Oil | COP | GV | 40.9% |
| S&U | SUS | DY | 108% |
| Pennant International | PEN | GV/PCF/DY | 44.8% |
| Unitech Corporate Parks | UCP | PBV | 12.5% |
| Average | - | - | 44.5% |
| Momentum Top 5 | - | - | 47.0% |
| FTSE Small Cap | - | - | 23.2% |
| FTSE Aim All-Share | - | - | 22.4% |
Source: Datastream
My cheap small cap screen draws on the methodology used by famed contrarian value investor David Dreman. While I personally sometimes feel uncomfortable with Mr Dreman’s strategy of focusing on the extremes of relatively narrow valuation metrics, such as the price-to-earnings (PE) ratio and dividend yield (DY), there is no doubt that the screen has delivered over the last year, and Mr Dreman has a well deserved reputation as a superb investment brain.
The screen starts out by looking at the cheapest quarter of all Aim and FTSE Small Cap stocks based on five metrics: PE, DY, price-to-cash-flow (PCF), price-to-book-value (P/BV), and what I’ve rather portentously named the genuine-value (GV) ratio (see box for more detail).
| The genuine-value ratio |
|---|
This is essentially a cash-and-dividend adjusted price-to-earnings-growth ratio, although its numerator ignores the tax rate. It takes the market cap of a company minus its cash and plus its debt (known as enterprise value or EV) divided by earnings before interest (interest being the product of the company's cash and debt) and tax (EBIT). This is compared with total return measure by average forecast EPS growth rate for the next two financial years (av. 2FY EPS gr) plus the historic DY. (EV/EBIT) / (av. 2FY EPS gr + DY) |
As well as being cheap on at least one of the five metrics the shares must also pass the following 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 than EPS H-1 plus EPS H-2. ■ Forecast EPS growth for each of the next two financial years. For shares qualifying based on a low GV ratio, I have eliminated any companies with an average forecast growth rate over the next two years of over 50 per cent as such strong growth could quickly 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 or net debt must be less than 2 times cash profits (EBITDA). ■ 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 I've insisted they pass both tests. ■ Dividend cover of 1.5 times or more, or above the three year average. ■ For low PE ratio and low PCF stocks I've also applied Mr Dreman's test that dividend yield should be above average (median average of all dividend paying stocks in the case of our screen), which reflects the importance he attaches to yield in achieving returns. |
There was a stronger showing from this years screen than last years with 21 stocks making the grade. I’ve provided a write up of the five qualifying stocks showing the strongest three-month momentum and the rest of the stocks are presented in the table that follows.
The cheapest small caps
