Shares in 'quality' large companies have performed strongly this year as bond investors, faced with rock-bottom yields, have used shares in reliable companies as an alternative way of securing solid long-term returns. However, the story has been less straightforward for 'quality' small caps. And the performance over the last year of my High Quality Small Caps screen seems to attest to this. While most of the shares from last year's screen have done well, one - notably Northbridge Industrial - has bombed (see table)
| Name | TIDM | Total return (13/08/14 - 7/08/15) |
|---|---|---|
| Maintel | MAI | 36% |
| Brainjuicer | BJU | 19% |
| Photo-Me Int'l | PHTM | 12% |
| Treatt | TET | 11% |
| Sepura | SEPU | 8.7% |
| Alternative Networks | AN. | 8.0% |
| Northbridge Industrial Services | NBI | -63% |
| Average | - | 4.3% |
| FTSE Small Cap | - | 11% |
| FTSE Aim | - | 1.0% |
| FTSE Small Cap/Aim | - | 6.0% |
Source: Thomson Datastream
Overall, the seven stocks selected by the screen last year delivered a 4.3 total return compared with 6.0 per cent from a combination of the FTSE Aim All-Share and the FTSE Small Cap indices. Since I started running the screen in the summer of 2012, the cumulative total return stands at 83.4 per cent compared with 40.7 per cent from the indices. Small caps can be costly to deal in, though, especially given the often punishing bid-offer spreads on such shares. If I factor in a 2 per cent charge to account for such costs, the total return from the screen drops to 72.6 per cent. Meanwhile, on a buy-and-hold basis the original 2012 screen has returned 95.4 per cent while the 2013 screen has delivered 45.3 per cent compared with 15.0 per cent from the market over the same period.
High Quality Small Caps versus FTSE Small Cap/Aim
Source: Thomson Datastream
The definition of 'high quality' used by this screen is based on two classic measures of operational performance - persistently high operating margins and high returns on equity.
A high operating margin is normally considered to be a sign that a company has some kind of advantage over other businesses, which allows it to charge a hearty mark-up on the goods or services it sells. This could be because it operates in an industry where there is a shortage of supply, or because its business has a particular lead over the competition - a strong brand or a patented technology, for example.
Return on equity is often considered to be the return an investor can expect from every new pound invested in a company. The measure is far from perfect, but it provides a pointer towards businesses that are able to make high returns and those that require little capital, which gives them the potential to expand quickly.
Unlike some of my other quality-focused screens, this one is also interested in valuation. It takes a two-pronged approach to the question of value. The screen eliminates the most expensive and cheapest stocks based on the price-to-earnings ratio, to avoid shares that are 'cheap for a reason' as well as those that are potentially dangerously overvalued. The screen then looks for stocks that are attractive based on a cash-and-dividend adjusted price-to-earnings-growth (PEG) ratio - something I've taken to calling a 'genuine value' ratio (GV). This GV ratio looks at a company's enterprise value (market capitalisation, plus debt, minus cash) compared with its operating profit (Ebit). This is then judged against the expected earnings growth rate plus dividend yield (DY). The formula is as follows:
(EV/Ebit) / (Forward EPS growth + DY)
The full screening criteria is:
■ PE ratio 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. |
When it comes to this year's High Quality Small Cap screen, it may be fair to say all that glistens is not gold. That's not to say the screen has not produced some interesting ideas. But deeper analysis of the cheapest three stocks demonstrates the narrowness of the screen's definition of 'quality'. What's interesting is that all three highlighted stocks are, in their own ways, attempting to address some of the issues the market has with their perceived quality. In total, 11 stocks passed the screen's tests. The cheapest three, based on the GV ratio, are looked at in more detail below while the remainder are published in the table that follows.
THREE HIGH QUALITY SMALL CAPS
