Led by investment director Graham Bird of Gresham House Asset Management, the asset managers have been successfully pursuing a public equity investment strategy, and specifically in my own small-cap hunting ground. There are more than 1,200 constituents of the FTSE SmallCap, Fledgling and Alternative Investment Market (Aim) indices, many of which have limited analyst coverage and often have limited access to growth capital. It's the main reason I specialise in this segment of the market, given the potential for uncovering value opportunities that are being largely overlooked by the wider market. It's no coincidence, either, that my 2017 Bargain Shares Portfolio, to be published later this week, is chock-full with anomalously priced small-cap value plays.
I am not alone in believing that following a value strategy, and a focus on the small-cap segment of the stock market, is a shrewd route to achieving above-average investment performance. Jonathan Dighe, commercial director of Gresham House, makes a strong case that the rotation from growth to value stocks, which started to gain traction towards the end of 2016, is likely to continue this year. Bearing this in mind, he highlights a significant gap between the ratings of larger and smaller shares in the FTSE All-Share index. According to Mr Dighe, the average prospective enterprise value to cash profit multiple for those companies with a market capitalisation above £250m is around 12.5 times, but only 7.3 times for those with a valuation below that level, suggesting "the valuation discount for smaller companies provides an opportunity to create superior long-term investment returns".
Of course, you still have to identify the right companies and management teams to back even if the valuations are attractive. So, Mr Dighe focuses on "those companies that can identify catalysts through either operational improvement, restructuring or strategic initiatives to create shareholder value over the long term". This is precisely what I look out for in my search for small-cap hidden gems that other investors have overlooked. Investment techniques I employ include targeting anomalously rated companies trading on sub-market PE ratios but with the potential for above-average earnings growth; special situations offering the potential for a return of capital to bring into sharp focus the mispricing; companies offering scope for multiple expansion driven by positive trading news, which in turn reduces the ratings gap with peers, or the general market; and companies recycling operating cash flow to enhance investment returns.
A playful investment
A good example of a small-cap company exhibiting some of these characteristics is Character (CCT:520p), the owner of a portfolio of 10 long-lasting iconic toy brands targeting the niche pre-school market. The company makes its money by licensing brands, developing products and then distributing them after outsourcing manufacturing to China. It's a global business as half the product range is for international companies, and a quarter of sales are overseas. These iconic brands account for over two-thirds of annual sales, which means the business is far less susceptible to the vagaries of a cyclical toy market characterised by the fleeting fads of children.
True, sales in the first four months of the financial year are shy of the comparable period in 2015, and management has needed to take action to counter the impact of sterling's devaluation on gross margins. But of far more importance is the news that the reaction of toy buyers to Character's "2017 product range and marketing plans has been excellent" and that the board "is confident that the new season's offering will deliver in terms of demand and sales at consumer level across both our UK and international operations".
Finance director Mark Dowding is certainly backing his own conviction, having just purchased £50,000-worth of shares. Moreover, a recent trading update highlighted that "the company's balance sheet including its cash position continues to strengthen considerably", so much so that the directors plan to maintain their very progressive dividend policy, and one that should see the payout lifted from 15p to 17p a share in the financial year to the end of August 2017, as analyst Peter Smedley at broker Panmure Gordon predicts. The board is not averse to share buybacks, either, a sensible use of surplus cash given Character's shares offer a 10 per cent earnings yield based on Panmure's adjusted EPS estimate of 49.9p.
So, having first recommended buying at 415p ('Playtime', 1 Jun 2015), since when the board has paid out dividends of 26p, and reiterated that advice at 485p ('Small-cap value plays', 5 Dec 2016), I still feel a price range between 625p and 675p is achievable. Buy.
Safestyle facing headwinds
Another small-cap highly cash-generative company is Aim-traded uPVC window company Safestyle (SFE:293p), a company I first advised buying shares in when it floated on the London junior market ('Window of opportunity', 23 Dec 2013). My 138p entry point has proved a bargain in hindsight as the share price has not only more than doubled in value, but the company has paid out total dividends of 35.5p a share. I last recommended buying at 275p, pencilling in a target price of 300p, which was surpassed last month when the share price hit an all-time high of 313p ('Clear cut investments', 19 Sep 2016).
The ability of the board to pay out over £29m of dividends in the past three years is a reflection of the prodigious cash generation of the business - almost 90 per cent of first-half cash profit was converted into operating cash flow last year. This is clearly attractive, as is the asset-light nature of the business, and Safestyle's cost advantage over rivals, which enables it to fabricate a product at a price point 20 per cent lower than some of its national competitors. In turn, the company has been able to invest in marketing efforts to attract a constant stream of new customers, buoyed since the summer of 2015 by a subsidised interest free credit offer, while at the same time gaining market share. Profit has risen sharply, too, as has the rating on the shares. Last week's pre-close trading update certainly offers substance to forecasts of a 15 per cent rise in Safestyle's EPS to 20.5p in 2016, reflecting a combination of price rises and better margins on the sales mix, as forecast by analyst Matthew McEachran at brokerage N+1 Singer.
There is a note of caution, though, as the wider industry is seeing input price pressures and generally lacklustre demand in the repair, maintenance and improvement market. This makes me cautious as does more aggressive pricing and marketing activity by competitors. Bearing this in mind, I think the risk:reward profile is no longer as favourable as it once given the earnings upgrade cycle looks to have run its course.
Moreover, in the absence of further upgrades, a forward PE ratio of 14 seems full in relation to the 4 per cent earnings growth predicted this year by analyst Andy Hanson at broker Zeus Capital. So, although the shares offer a prospective dividend yield of 4 per cent based on Zeus's latest forecasts, and Safestyle retains a cash-rich balance sheet with net funds of around 16p a share, I feel it's time to crystallise the 138 per cent paper profit on this holding if you have been following my advice. Take profits.
Hitting target prices
A high conversion rate of profit to cash flow is a key reasons I recommended buying shares in Aim-traded CareTech (CTH:367p), a leading provider of specialist social care services, supporting adults and children with a wide range of complex needs. It's been a slow burner as I initiated coverage when the share price was 230p ('Time to take care', 16 Mar 2015), and it was only marginally above that level last summer ('CareTech on major buying spree', 23 Jun 2016).
However, investors have been warming to full-year results released at the end of last year, so much so that CareTech's share price has soared through the 345p target price I outlined when I rated the shares a buy around the 300p mark in mid-December ('On the money', 12 Dec 2016). It's easy to see why because, buoyed by £34m of operating cash flow, the board was able to raise the dividend per share by 10 per cent to 9.25p and there are prospects of further hikes to come. There is also hidden value in the balance sheet as the company's freehold estate of properties have been independently valued by commercial surveyors at £304m, a hefty premium to their £267m carrying value in the accounts. Mark property to market value and book value per share is not far off 300p.
Furthermore, even after the re-rating, CareTech's enterprise value of £395m, which factors in net borrowings of £156m and the current market capitalisation of £239m, equates to only 10 times this year's likely cash profit based on the forecasts of analyst John Cummins at broker WH Ireland, still below the multiples achieved in recent bid activity across the sector. In light of this, I have revisited my own target price and feel that an enterprise value to cash profit multiple of 10.5 to 11 times is more reasonable, implying an equity valuation of between 412p and 450p a share. Buy.
CareTech is not the only cash-generative small-cap company on my watchlist that has been hitting my target price. The same is true of Aim-traded shares in stockbroker and financial services outsourcer Jarvis Securities (JIM:370p), which I recommended buying at 305p in mid-November ('High-yielding income play with capital upside', 15 Nov 2016). That advice couldn't have been better timed because a few weeks later the UK stock market started a substantial rally. The marked change in investor sentiment will have come too late to prevent Jarvis turning in a flat profit performance last year, as analyst Nick Spoliar of house broker WH Ireland predicts it will report adjusted pre-tax profit of £3.5m and EPS of 25.1p on revenue of £7.6m. But it should have a positive bearing on this year's performance if the company's 100,000 retail clients who use its ShareDeal-Active and X-O low-cost online share trading services have increased their transactional activity.
Also, we are still awaiting news on whether Jarvis's corporate division, which provides outsourced and partnered financial administration services to a number of third-party organisations, has been successful in finalising a major contract with a financial services company. I outlined the likely profit implications of this in my November article. I also made the case that irrespective of the outcome of discussions on finalising that deal, the shares were still worth between 375p and 400p, a price range that was hit last week.
However, taking into consideration the improved trading prospects for both divisions, then I feel that my target price is erring on the conservative side. Indeed, underpinned by the cash-generative nature of the business model, the shares still offer a 4.7 per cent dividend yield based on a 17.5p a share annual payout, and one that reflects the board's progressive policy to pay out a high percentage of earnings to shareholders as quarterly dividends. Also, it's worth taking into account that the company's growing cash pile now equates to 30 per cent of its market capitalisation of £40m.
In the circumstances, a target price of 425p seems a fairer valuation and that's ignoring the potential for Jarvis to win lucrative contracts on its corporate side, an update on which can be expected when the company reports its full-year results on Thursday 16 February. Buy.
MORE FROM SIMON THOMPSON...
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The archive of all the share recommendations I made in 2016 is available here
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