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Five cheap hot small caps

Terrible conditions on Aim have made for a very bad year for my cheap small-caps screen, but the 14 picks for 2015 look an interesting bunch
April 1, 2015

It's been a testing 12 months for small-cap shares, and particularly those traded on Aim. That's made for an appalling run from last year's cheap small-caps screen, which produced a 19.1 per cent negative total return, compared with the 16.1 per cent loss from the FTSE Aim All-Share and a positive 5.4 per cent from the FTSE Small Cap.

Most of last year's share picks (18 out of 21 stocks, or 86 per cent) came from Aim, where a rising sense of wariness about the prospects and reporting standards of companies became a theme of the last year. A 'cheap' valuation is often a signal that the market is already somewhat dubious about a company and a number of last year's cheap small-cap picks were slaughtered by the darkening sentiment.

 

NameTIDMTotal return (18 Mar 2014 - 25 Mar 2015)
Northbridge Industrial ServicesNBI12.3%
GloboGBO6.7%
OPG Power VenturesOPG4.7%
ClinigenCLIN3.5%
Central Asia MetalsCAML2.8%
MacfarlaneMACF0.9%
InternetQINTQ0.5%
FairpointFRP0.0%
Impax Asset ManagementIPX-0.2%
Frenkel ToppingFEN-7.4%
DialightDIA-8.9%
Steppe CementSTCM-11.3%
Exillon EnergyEXI-17.6%
Jarvis SecuritiesJIM-20.8%
UtilitywiseUTW-34.8%
Gable HoldingsGAH-43.7%
NetplayNPT-49.7%
Circle OilCOP-54.7%
Rambler Metals and MiningRMM-61.5%
Pressure TechnologiesPRES-63.6%
Naibu GlobalNBU-85.0%
FTSE Small Cap-5.4%
FTSE Aim All-Share--16.1%
FTSE Small Cap/Aim All-Share blend--5.4%
Average--19.1%

Source: Thomson Datastream

  

Last year's underperformance almost eclipsed the very strong outperformance this screen boasted in its first outing in 2013. Indeed, the cumulative total return now stands at 16.0 per cent, compared with 27.9 per cent from the FTSE Small Cap and a negative 0.3 per cent from the FTSE Aim All-Share. A blend of the two indices produced a 13.8 per cent return over the period, which is probably the best benchmark for the screen. If I factor in a 2 per cent charge to account for dealing costs, including the wide spreads that smaller companies often trade on, then the cumulative total return from the screen falls to 11.4 per cent.

 

Cheap Small Caps versus Index

 

The torrid experience last year illustrates some of the dangers of looking for 'cheap' stocks and the limitations of stock screens. Indeed, it is hard for a screen to measure matters of sentiment or the potential for big macro changes, such as the recent fall in commodity prices. That said, a low valuation can in itself allude to trouble on the horizon, so in some ways looking for 'cheap' shares puts you into the danger zone. Meanwhile, smaller companies do appear to have moved from a period when investors were fairly happy to take reported numbers as fact, to a situation where there are many more questions being asked, which is not a bad thing.

However, while I expressed my nervousness last year about this screen's tactic of looking for extreme value, which is inspired by famed contrarian investor David Dreman, the strategy does produce some very interesting results, even if last year's experience was a painful one. What's more, the screen does use a number of Dreman-inspired tests to try to separate the wheat from the chaff.

The screen starts by looking for the cheapest quarter of stocks based on one or more of five valuation measures: the forecast next-12-months price-earnings ratio (Fwd NTM PE), the historic dividend yield (DY), price-to-cash-from-operations (PCF), price-to-book-value (PBV) or my genuine-value ratio (GV). A fulsome explanation of the GV ratio can be found in last week's screen, but it's broadly similar to a price-earnings-growth ratio (PEG) adjusted to account for dividends paid and a company's debt. Companies that are found to be cheap on one or more of the five valuation measures then have to pass several extra tests, which vary slightly depending on the valuation criteria they've qualified on. The extra tests are:

 

 

I have provided short write-ups of the five qualifying shares with the strongest three-month momentum below and the remaining eight shares are listed in the table that follows.