Join our community of smart investors

Five Small-Cap Special Situations

STOCK SCREEN: Fortune favoured the brave last year with my six small-cap special situations delivering a total return of 31.3 per cent compared with 22.9 per cent from the FTSE Small Cap. Five high-risk shares make the grade this year.
April 8, 2014

With hindsight, I chose a good time to introduce my small cap special situation screen last year. Small caps have had a storming run over the last 12 months and stocks with extreme valuations have been carried with the market. Indeed, between them the six high-risk small-cap special situations picked by the screen last year delivered a 31.3 per cent total return (see graph) compared with 22.9 per cent from the FTSE Small Cap and 19.7 per cent from FTSE AIM All Share - the indices from which the stocks were picked.

While my total return performance data does not account for the bid-offer spread, which can be particularly wide with small caps, the performance of the six stocks from last year’s screen has, to my surprise, not included any massive disappointments. Indeed, while Argo, the worst performing share, flat lined in a buoyant market, none of the stocks are showing a negative mid-to-mid return (see table).

NameTIDMTotal Return (8 Apr 2013 - 1 Apr 2014)
Pure WaferPUR86.0%
Livermore InvestmentsLIV46.6%
Steppe CementSTCM35.3%
Argo GroupARGO0.0%
BP Marsh & PartnersBPM14.1%
Local Shopping REITLSR5.5%
Average-31.3%
FTSE AIM All Share-19.7%
FTSE Small Cap-22.9%

Source: Datastream

The across-the-board resilience of the stocks is such a surprise because the screen looks for signs of extreme cheapness based on share price (P) compared with tangible book value (TangBV) per share, and these kind of stocks are often “cheap for a reason”. And while tangible book value has the advantage of focusing on the value of a company’s physical assets, the value of such assets can still easily be overstated in a company’s books, especially if trading has deteriorated significantly from the time the valuation of an asset was first arrived at.

While the general rise in small cap valuations means I’ve had to ditch my previous arbitary P/TangBV maximums of 0.75 and 0.6 for investment companies, I am still insisting on a very low valuations - I am only interested in the cheapest quarter of all stocks screened (a P/TangBV of 0.93 or less) or the cheapest 15 per cent (0.74 or less) in the case of investment companies. Normally such valuations point to real trouble – Punch being a classic example this year’s screen.

That said, this screen does use tests to assess the general underlying health of companies in order to try and avoid the worst dogs on the market. These tests are based on both underlying fundamentals and the cue given by the market itself based on above-average three-month share-price momentum – shares have to be up by more than -1.5 per cent over three months.

In addition to the low-P/TangBV test and momentum test the stocks have to satisfy the following criteria:

■ Rising underlying earnings based on EPS for the most recent half year (H0) plus EPS H-1 compared with EPS H-1 + EPS H-2. Where companies have been loss making, positive earnings must have been reported in the most recent half.

■ A current ratio of more than 1

■ Positive free cash flow last year

■ Market cap of £10m or more

Only five stocks made it through the screen and one of these, Punch, looks an out-and-out punt. The stocks are ordered by cheapness based on their P/TangBV