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Run-away returns from high-growth small caps

Last year's Martin Zweig-inspired small-cap stock screen delivered a 46.5 per cent total return compared with 11.3 per cent from the FTSE Small Cap and 3.9 per cent from the FTSE Aim All-Share. I've found 15 new high-growth small caps for this year's portfolio.
September 17, 2014

The famous US growth investor Martin Zweig used to distinguish between using a shotgun or rifle when hunting investments. This column would certainly fall into the shotgun category. That is to say, while stock screens cannot hone-in on the nuanced characteristics of individual companies, they are able to take aim at huge numbers of companies and use a scatter shot method to try to hit winners while accepting some losers may be bagged along the way. By contrast, a rifle approach - more suited to big game hunting - requires an investor to devote a huge amount of attention to the ins and outs of an individual stock. This can be very profitable, but it is extremely labour intensive and if an investor’s aim is off, then the single bullet is wasted.

Mr Zweig was a proponent of both approaches, but last year’s Zweig-inspired small-cap screen certainly gives credence to his shotgun antics. The screen actually only produced five results in 2013, so last year's 'shotgun' had a limited spread. The overall result was extremely impressive, though, as the screen delivered a 46.5 per cent total return compared with 11.3 per cent from the FTSE Small Cap and 3.9 per cent from the Aim All-Share. Of particular note was the jaw-dropping 168 per cent total return from Solid State (see table), a company that appears again in this year’s screen. And Dart Group was the only one of the five shares to underperform with a negative total return of 14.2 per cent.

NameTIDMTotal Return (3 Sep 2013 - 5 Sep 2014)
CranewareCRW30.9%
Solid StateSSP168%
Brooks MacDonaldBRK14.5%
Dart GroupDTG-14.2%
Advanced Medical SolutionsAMS33.7%
Average-46.5%
FTSE Small Cap-11.3%
FTSE Small Cap/Aim blend-7.6%
FTSE Aim All Share-3.9%

Source: Thomson Datastream

 

This result builds on a decent first year performance from the screen in which it substantially beat the Aim All-Share (from which most of the shares were drawn) but fell short of the stellar return from the FTSE Small Cap. However, on a cumulative basis, the screen is now substantially outperforming both indices (see graph) boasting an 87.3 per cent total return compared with 51.4 per cent from the Small Cap and 16.3 per cent from the Aim All-Share. That said, it needs to be noted that my performance figures do not take account of dealing costs or share price spreads, which can be particularly pernicious for small cap investors.

Zweig vs Small Caps

Source: Thomson Datastream

 

While my Zweig screen is best described as an 'interpretation' of the process Mr Zweig set out in his book 'Winning on Wall Street' rather than exact imitation (this is necessary to get a decent number of results from UK small caps), it hopefully captures the obsession with growth that he had. The idea is that shares should have a strong growth record and be displaying very strong recent growth too. There is little focus on valuation, although, Mr Zweig believed it best to avoid anything that was very cheap or very expensive. There is also a soft financial-strength test. Mr Zweig’s main concern with high debt was that a company burdened with high interest payments could see earnings growth deteriorate very quickly if trading got a bit tougher. The full list of criteria I’ve used for this screen is as follows.

■ A five-year EPS compound annual growth rate (CAGR) of 15 per cent or more,

■ A five-year revenue CAGR of at least half the five-year EPS CAGR,

■ EPS growth in last year of 15 per cent or more,

■ EPS growth in last half year of 15 per cent or more,

■ EPS growth in each of the last three years and at least four of the last five years,

■ EPS growth in each of the last two half-year periods,

■ Net debt to cash profits of 2.5 times or less,

■ A PE ratio above the lowest 10 per cent of all stocks and below the highest 20 per cent.

Only one company passed all 10 tests this year so, to get a decent number of results, I have been forced to soften the screen up a bit by insisting only nine of the 10 criteria are met. Fifteen companies made the grade on this score. I’ve provided brief write-ups of the investment case for five of these stocks below. The five I’ve selected are based on the only company that the screen gave full marks to and then the four stocks boasting the highest three-month momentum, the lowest 'Genuine-Value' ratio*, the lowest forecast PE and the highest dividend yield. The other 10 stocks are listed in the table that follows the write-ups.

*The Genuine Value ratio is a similar to a price-to-earnings growth ration adjusted to account for a company’s cash and debt and dividend yield. The formula is:

(EV/EBIT)/(Average forecast EPS growth for the next two financial years + DY).

Top Marks - Brooks MacDonald

Stock screening is a fickle business and had I run this screen after 17 September, when wealth manager Brooks (BRK) is due to publish full-year results, the stock would not have qualified as a Zweig pick. But while the accolade of being a Zweig stock may soon be taken from Brooks, there are good grounds to think missing out on the investment opportunity would be unfortunate.

True, a small earnings dip is expected from the group for the financial year it completed at the end of June. But that is a reflection of the substantial investment drive it has to make to accommodate anticipated future growth. Indeed, while profits may not be powering higher in the 2013/14 financial year, the company has already said that assets under management have grown by 28 per cent, which mostly reflect new business wins rather than a rising stock market.

Broker Numis is forecasting that after reporting adjusted EPS of 83.6p this year, down from 85.9p in 2013, EPS will begin to grow again to 99.5p in the new financial year and then 115p in the 12 months to the end of June 2016. Ironically, even once Brooks is back on the growth course, it will for some time no longer qualify for this screen’s test for consistent three years EPS growth.

Mkt capPricePEFwd NTM PEDYPEGGV ratioP/BV
£193m1,450p22161.6%1.030.673.19

FY EPS gr+1FY EPS gr+2Av EPS gr FY2*3-mth momentumNet cash/debt (-)
24.4%15.1%21.6%-4.0%£15m

Source: S&P CapitalIQ

*Consensus forecast growth in the table refers to the next two financial years to Jun 2015 and Jun 16 and not Jun 14

Last IC View: Hold, 1,730p, 13 Mar 2014

 

Highest 3-Month Momentum - Solid State

Shares in niche electronics group Solid State (SSP) have made it back into the Zweig small-cap portfolio after delivering a knockout 168 per cent total return over the past 12 months. And the incredible thing is that after such a strong run, the shares don’t even look that expensive.

Indeed, on a number of measures they appear cheap. They boast the lowest PEG ratio (historic PE ratio divided by average forecast growth for the next two financial years) and the second lowest GV ratio (a PEG adjusted to take account of cash, debt and dividends) of all the shares passing the screen.

The reason the shares appear such good value on these measures is due to the phenomenal growth expected from the company. A key reason for this has been Solid State winning a three-year contract to supply electronics for the UK’s electronic-tagging scheme. Successfully pulling off such a high-profile contract will set out the group’s stall when bidding for other major contracts. In the meantime, the tagging work provides very secure foundations for profits growth, the lion's share of which will be seen in the year to March 2016.

Mkt capPricePEFwd NTM PEDYPEGGV ratioP/BV
£50m605p24181.4%0.510.474.78

FY EPS gr+1FY EPS gr+2Av EPS gr FY23-mth MomentumNet cash/debt (-)
17.9%64.7%47.1%51.7%-£2m

Last IC View: na

Lowest GV Ratio - M Winkworth

London-focused estate agent franchise chain M Winkworth (WINK) has been making hay while the sun shines, thanks to boom conditions in the capital’s residential property market. But the City has begun to get a lot more nervous about the prospects for London residential property and that'sbeen exacerbated by the traditional summer lull in the property market. And with about four fifths of its business in London, Winkworth’s shares have struggled.

But there are few tangible signs yet of the business itself struggling. First-half revenue growth came in at 20 per cent and the franchise structure of the business means sales increases have a disproportionately large impact on the bottom line. Indeed, first half underlying post-tax profits were up by a third.

And the future is not necessarily going to be doom and gloom for Winkworth (as attested to by bullish broker forecasts). Indeed, there are some hopes that prices in London will now stabilise - as opposed to drop - which could encourage more sellers to put their properties on the market, thereby boosting transactions. Meanwhile, Winkworth is expanding its out-of-London network which is focused on towns that Londoners tend to move to once they cash in their property chips in the capital. This business is doing extremely well and reported a 43 per cent increase in first-half transactions.

Mkt capPricePEFwd NTM PEDYPEGGV ratioP/BV
£21m165p16-3.3%0.670.394.98

FY EPS gr+1FY EPS gr+2Av EPS gr FY23-mth momentumNet cash/debt (-)
--24.6%-5.3%£3m

Last IC view: Buy, 165p, 11 Sep 2014

 

Lowest Forecast PE - Connect

Companies that are valued lowly against earnings or dividend, as Connect (CNCT) is on both counts, often face big challenges. That’s the case with newspaper and books distributor Connect, which was previously known as Smiths News.

The company’s newspapers and magazines business is in long-term decline as more and more is read online. That said, this division has actually been trading well recently buoyed by strong football World-Cup related sales (sticker books etc). But Connect’s books business has been a drag. Margins are under pressure due to weak academic and library demand. Management has taken action to address this, though, and the business is judged to have stabilised. Meanwhile the education and care business is performing as expected.

This mix of good-and-bad feeds into some pretty uninspiring broker EPS forecasts, which predict modest decline over the next few years. While there is little in that to get one’s heart racing, the fat dividend yield is not something to be ignored and it would require very little in the way of good news to lift the shares off their current depressed rating.

Mkt capPricePEFwd NTM PEDYPEGGV ratioP/BV
£294m156p1086.0%-2.49-

FY EPS gr+1FY EPS gr+2Av EPS gr FY23-mth momentumNet cash/debt (-)
-3.3%-3.2%-3.2%-22.2%-£106m

Last IC view: Buy, 165p, 23 April 2014

 

Highest Dividend YieldPan African Resources

Like Brooks MacDonald (see above), time as a Zweig stock is going to be short lived for precious-metal miner Pan African Resources (PAF). Indeed, while the historic track record is strong, the company has warned that underlying EPS this year will be about 45 per cent down on last year, and results are due to come out between the time of running this screen and this article's publication. But the lowly rating now attributed to the shares means that they look like a very tempting proposition for those prepared to look past this year’s profits and to the potential for a recovery back to previous levels while enjoying hearty income along the way.

Pan African’s profitability problems are related to the fact that it has recently been mining from a patch of lower quality ore. While management expects the ore grades it is mining to now start to improve, the situation has persisted for longer than expected already. The company is trying to find ways to get to better ore, though, and in the meantime has said it will maintain its final dividend in rand terms.

Research house Edison puts a sterling value of 0.78p on this year’s dividend payment, which is down from 0.83p last year but still equivalent to a handsome 5.6 per cent yield. Edison also points out that the shares are valued at a much lower earnings multiples than rivals as well as offering vastly superior income.

Mkt capPricePEFwd NTM PEDYPEGGV ratioP/BV
£247m14p5106.1%--1.60

FY EPS gr+1FY EPS gr+2Av EPS gr FY23-mth momentumNet cash/debt (-)
-37.4%12.5%-14.8%-3.6%-£8m

Last IC view: Speculative buy, 15p, 20 February 2014

The Rest

NameTIDMMkt CapPriceFwd NTM PEDYPEGGV RatioP/BVAv. EPS gr FY23-mth MomNet Cash/ Debt(-)
Brainjuicer AIM:BJU£55m433p200.9%1.981.056.7011.7%2.7%£6m
Walker Greenbank AIM:WGB£115m193p201.0%13.07.004.211.8%4.6%£1m
Porvair LSE:PRV£127m288p201.0%--2.61-10.1%-7.0%-£1m
IDOX AIM:IDOX£151m43p161.7%--3.16-4.8%-2.0%-£9m
Mountview Estates LSE:MTVW£313m8,025p-2.5%--1.18--3.3%-£77m
Portmeirion AIM:PMP£94m893p152.7%3.081.553.185.5%13.7%£3m
Churchill China AIM:CHH£57m518p172.9%--1.99-10.2%£8m
S&U LSE:SUS£216m1,822p133.0%0.74-3.1121.9%-4.5%-£33m
Gable Holdings AIM:GAH£106m79p9-1.491.043.3110.5%-3.9%£27m
Intl Biotech Trust LSE:IBT£173m318p----0.84-13.7%-£2m

Source: S&P CapitalIQ