In the two years since I started running my High Quality Small Cap screen, shares in smaller companies have soared. Indeed, over the period, and despite recent turbulence, the FTSE Small Cap index has produced a mammoth 50.6 per cent total return. That has been a great tailwind for the screen and following another strong 12 months, during which it delivered a 28 per cent return, it is now showing a cumulative total return (excluding dealing costs and spreads) of 75.5 per cent over two years (see graph).
High quality small caps vs indices
While focusing on 'high quality' companies should in theory limit risk, small caps are inherently risky and the performance of the five shares picked by the screen in 2013 varied widely. What’s more, one of them, Globo, has come under heavy fire from short sellers that have been questioning why the company generates so little cash and why so much of its sales are booked as receivables (work invoiced for but not paid for by the customer). So the screen's claims of picking high quality shares needs to be taken with a pinch of salt. Screening by nature is always a somewhat blunt instrument. That said, Globo actually put in a good performance last year and the screen also picked an absolute belter of a stock with Tracsis (see table).
| Name | TIDM | Total Return (31 Jul 2013 - 5 Aug 2014) |
|---|---|---|
| Globo | GBO | 19.4% |
| Brightside Group (taken over) | BRT | -10.8% |
| RWS Holdings | RWS | 9.5% |
| E2V Technology | E2V | 18.3% |
| Tracsis | TRCS | 103.7% |
| Average | - | 28.0% |
| FTSE All Share | - | 5.6% |
| FTSE Small Cap | - | 10.6% |
| FTSE Aim All Share | - | 6.2% |
Source: Thomson Datastream
The screen’s premise is pretty basic. It looks for companies that have businesses that are of higher than average quality but shares that offer better than average value. The average measure I have used is based on the median average rather than the mean to avoid distortions created by a few incongruously low or high readings.
Quality
I have not been very exotic in my choice of criteria for measuring business quality with this screen. The two criteria used are classics: return on equity (RoE) and operating margin. RoE is often regarded as a measure of the return a company can be expected to make on every new pound invested in its business. It's a somewhat crude but often effective measure of quality. Meanwhile, high operating margins are generally considered to be a decent indication that a company has some kind of competitive advantage. This could come down to things like brand, intellectual capital or technology. While neither measure of quality is without fault, I think looking at both together gives the screen a decent chance of finding businesses that have something special about them.
The screen is also only interested in companies that can show some consistency in producing above average RoE and operating margins, as it looks for companies that have been above average in each of the last three years. In addition, the screen demands that things are getting better rather than worse by requiring that both RoE and margins are higher than three years ago.
Value
I’ve used my 'Genuine Value' (GV) ratio (see formula below) to assess value. Using this ratio acts as something of a quality filter in itself as it can only be calculated for companies that are profitable and have brokers forecasting earnings two financial years out. To be selected by the screen, stocks have to be cheaper than average based on this measure of value.
While the GV ratio covers many valuation bases, I have also added in a few additional tests to fine tune the screen’s results on the valuation front, such as insisting that earnings growth is forecast in both of the two financial years looked at (see criteria below). The screen also excludes stocks which are either extremely cheap or expensive based on their historic price-to-earnings (PE) ratio. This is because stocks at either end of the valuation spectrum tend to have very high risks associated with them, as they often tend to either be overvalued or to be no-hopers.
GV ratio formula
Enterprise-value-to-operating-profit ratio/Average forecast earnings growth for the next two financial years plus dividend yield
or
(EV/EBIT)/(Average (EPS gr+1 and EPS gr+2) + DY)
Full High Quality Small Cap Criteria
■ PE above bottom fifth and below top fifth of all stocks screened
■ Lower than median average GV ratio
■ Earnings growth forecast for each of the next two years
■ Interest cover of five times or more
■ Positive free cash flow
■ Market cap over £20m
■ Higher than median average RoE in each of the last three years
■ Higher than median average operating margin in each of the last three years
■ RoE growth over the last three years
■ Operating margin growth over the last three years
■ Operating profit growth over the last three years
I’ve screened all the stocks in the FTSE Small Cap and FTSE Aim All Share and seven have met all the above criteria. They are ordered below from lowest to highest GV ratio.
