10 deep-value small-cap special situations

2016 performance

Source: Thomson Datastream

The past 12 months was a good time to be on the hunt for companies trading at wide discounts to tangible book value (P/TangBV) - the key valuation metric used by this screen. Many resources stocks displayed this characteristic at the start of the period and it was the strong recovery in this sector that was largely responsible for the big gains recorded by the indices. Indeed, all of the six stocks from last year's screen that delivered total returns of 50 per cent or more had a focus on resources (agriculture, in the case of Obtala). But while the average outperformance of the screen was very impressive, as the table below demonstrates, there were some big losers sat alongside some massive gains. This reflects the significant risks involved with this strategy. The risks are also reflected in my table showing the annual gains and losses from this screen, which include an awful 38 per cent negative total return in 2015 as well as a preposterously outsized 112 per cent gain in 2014.

Year-by-year performance

Source: Thomson Datastream

While this screen has hardly provided a comfortable ride, the cumulative return is extremely strong, at 143 per cent compared with 52 per cent from a blend of the FTSE Small Cap and Aim. However, this figure ignores dealing costs, which are particularly significant for a strategy focused on out-of-favour small-caps, which can have pernicious spreads. To try to account for this very unattractive aspect of small-cap, deep-value investing, I also calculate returns building in a fulsome 4 per cent annual charge. Once this is factored in, the cumulative return drops to 106 per cent. That's still more than double the combination of the Small Cap and Aim indices, although many may see this as insufficient compensation for the bumpiness of the ride.

'Tangible' book value represents a company's physical (tangible) assets less borrowings. In the case of a struggling company, this portion of book value can often be regarded as having potentially better resale value than its more ephemeral 'intangible' assets. However, while some of the shares this screen highlights are very much a play on asset disposals (see the write-up of Local Shopping Reit below, which is currently trying to liquidate its portfolio), the best upside from such situations is to be found with companies that could make their cheaply valued asset base substantially more productive, thereby achieving a large re-rating of their shares. In this case the company's tangible assets can be regarded as a measure of a company's recovery potential. The screen therefore uses a number of tests to gauge whether both sentiment and trading are moving in the right direction, which may point to a recovery in the offing. The screen also uses a couple of soft tests for cash flow and balance sheet strength (the current ratio). The full screening criteria are:

■ P/TangBV in the lowest quarter of all stocks screened, or the lowest 15 per cent for investment companies.

■ Three-month share price momentum higher than the median average.

■ Year-on-year EPS increase in the most recently reported six-month trading period.

■ A current ratio (current assets divided by current liabilities) of more than one.

■ Positive free cash flow last year.

■ Market capitalisation of more than £10m.

In the past I've sometimes had to weaken the tests to get results, if I've simply had very few positive results (only four shares made the grade in the screen's 2015 annus horribilis, for example). Therefore, the fact that 10 shares passed muster this year represents a pretty good result. All the picks appear in the table below, which is ordered from lowest to highest P/TangBV. I've also taken a closer look at the cheapest and most expensive shares, along with one from around the middle of the table.

10 deep-value small-cap special situations

Source: S&P Capital IQ

Sylvania (SLP) is a Bermuda registered, Aim-traded, South African platinum miner. The company has two strands to its business. One involves re-treating platinum-rich chrome tailings and the other focuses on low-cost, shallow, opencast mining. As is typical with miners, the price of the metals it digs and processes, as well as the local currency (the rand) in which costs are denominated and cash is held are key influences on the share price. Platinum has been somewhat weak recently and political tribulations in South Africa have recently led to a sharp fall in the rand.

Aside from these two major external factors, there have been positive developments at the company recently. At the half-year stage it marginally increased its guidance for full-year production from 60,000 ounces (oz) to 63,000-65,000 oz. The company is also sitting on a decent cash pile - albeit with rand exposure - which should help it fund its four-year $12m investment programme to substantially boost its mine life. There are also hopes that the cash position will support the payment of a long-awaited maiden half-year dividend.

The company's exploration assets could also hold upside. One of its two big prospects is being marketed for sale, while development of the other is on hold pending an improvement in market conditions. The balance sheet puts a $55m value on these assets, although broker Liberum does not factor them into its own forecast of net present value, which stands at $67.6m (last IC View: None).

Local Shopping Reit's (LSR) name alone is probably enough to strike fear into most investors' hearts. Can a case be made for investing in local shopping assets with the UK's high streets facing the existential threat of online shopping and a plethora of more specific challenges - from rising business rates to wage increases? Shareholders have already answered the question with a 'no'. In 2013 they voted for the company to be wound up and for capital to be returned.

The fact the portfolio is now being sold off makes the near-30 per cent discount to net asset value look interesting because this is all potential upside waiting to be realised through the liquidation process. The trouble is, the company owns a disparate collection of urban and suburban retail properties that may continue to prove hard to sell. Indeed, three attempts to sell the properties as a portfolio have failed after the signing of heads of terms.

The company is now in the process of trying to create a core portfolio valued at about £55m by selling off smaller, more difficult units at auction and in the open market. Given the nature of these sales, there is a higher possibility of the company achieving disappointing prices, the effects of which would be magnified for shareholders by the fact the company, at the full-year stage, had net debt of £40m, equivalent to 53 per cent of its £75m property portfolio. To date, while some properties have been sold at way below book value, others have fetched a premium. What's more, once 2017's sales are over, investors may be prepared to put more faith in the valuation of the higher-quality core assets. The plan would be to sell this core as a portfolio which, if successful, could mean a relatively speedy return of cash to shareholders (last IC View: None).

At the time of writing, Camellia's (CAM) full-year results are due imminently. These should shed light on how the business and balance sheet look following a period of noteworthy change. A new management team that took the helm in 2015 has been working on sharpening the focus of the mini-conglomerate through disposals and the closure of underperforming operations, while improving the clarity of disclosure about its disparate operations and increasing efficiency.

A key event during 2016 was the sale of the company's Duncan Lawrie banking and asset management businesses for a total of £71m. This was a welcome move, as not only did Camellia get a decent price for the assets it sold, but it has also exited at a time when the regulatory burden associated with the operations was expected to increase. Low interest rates were also weighing on profitability.

The money from the sales can now be redirected into the group's other operations, especially its international agricultural interests where there should be good long-term growth potential based on demographic changes and middle-class growth in emerging markets. The company is looking to reduce the impact of crop prices on its tea business and move up the tea 'value chain' with new products such as green tea. It is also looking to expand the agricultural businesses considered less volatile, such as macadamia nuts and avocados. The group is considering leasing land to grow these operations rather than its current strategy of buying it, which requires more upfront capital.

While Camellia appears to see its best opportunities in agriculture, prospects should be improving for its engineering business, too, based on the revival in the oil price. The group's engineering division has significant exposure to the Scottish oil market. So while recent numbers from the group have been uninspiring, there is the potential for a better narrative to emerge as the company sharpens its focus and as end markets rebound. Coupled with the company's attempts to provide shareholders with increased visibility on the performance of its various divisions, this could provide the fuel the shares need to continue moving higher (last IC View: Sell, 8,400p, 30 Aug 2016 ).