Cheap shares are almost always cheap for some reason or another. A value opportunity tends to exist when the reason in question is holding sway. Stock screens offer only a fairly basic approach when it comes to trying to evaluate the reasons behind a stock's apparent cheapness. This is particularly true of small caps, where the nitty gritty of a company's history and its accounts often matter a great deal.
But there are also some important factors that work in favour of screens which focus on finding cheap shares. One is that the market has a tendency to overreact to bad news, which means screens can often land on stocks that have been excessively marked down. Another important advantage of searching out cheap shares is that a lot of negative sentiment is already priced in, meaning more bad news may do relatively little damage to the share price.
So while screening for cheap shares can be expected to come up with real duds due to the limits of the approach, it can also find some diamonds which means the overall result can often be good. That was certainly the case with last year's Cheap Small Cap screen, which produced a 19.5 per cent total return from 13 stocks compared with 0.5 per cent from a combination of the FTSE Small Cap and FTSE Aim indices.
| Name | TIDM | Total return (1 Apr 2015 - 21 Mar 2016) |
|---|---|---|
| 32Red | TTR | 149% |
| MacFarlane | MACF | 70.4% |
| Tristel | TSTL | 67.3% |
| Alumasc | ALUM | 22.2% |
| NewRiver Retail | NRR | 13.3% |
| Central Asia Metals | CAML | 0.8% |
| F&C UK Real Estate | FCRE | -0.2% |
| Plus500 | PLUS | -1.2% |
| M Winkworth | WINK | -1.7% |
| Laura Ashley | ALY | -3.9% |
| Creston | CRE | -8.1% |
| Impax Asset Management | IPX | -18.3% |
| Getech | GTC | -35.0% |
| Average | - | 19.5% |
| FTSE Small Cap | - | 1.2% |
| FTSE Aim All-Share | - | -0.1% |
| FTSE Small Cap/Aim | - | 0.5% |
Source: Thomson Datastream
Last year's strong result followed a very poor run in 2014, which was preceded by a good year. In total, over the three years that I've run this screen the cumulative total return is good, coming in at 37.7 per cent versus 13.6 per cent from a combination of the FTSE Small Cap and Aim All-Share. If I factor in a 2 per cent charge in an attempt to reflect the costs involved in reshuffling the portfolio every year, the cumulative return drops to 29.6 per cent.
Cheap Small Caps versus indices
The screen itself is based on the approach espoused by contrarian investor David Dreman, although Mr Dreman's interest is in medium and larger companies. The screen looks for the cheapest quarter of stocks from the FTSE Small Cap and Aim All-Share based on several common value ratios: price-to-earnings (PE), dividend yield (DY), price-to-book-value (P/BV), price-to-cash-flow (P/CF) and my 'genuine value' ratio, which is a kind of dividend-and-net-debt-adjusted price-to-earnings ratio.
The screen then looks for several indicators that the stocks may be better than the valuation is giving them credit for. It should be noted, the tests applied are slightly different depending on which valuation criteria a stock has qualified against. The supplementary tests are as follows:
■ Underlying year-on-year EPS growth in the most recent half-year period. ■ Forecast EPS growth in each of the next two financial years. For shares qualifying based on a low GV ratio, I have eliminated any companies with an average forecast growth rate over the next two years of over 50 per cent, as such strong growth could prove unsustainable. ■ A current ratio (net current assets/net current liabilities) of more than one, which suggests a company is in a good position to pay its upcoming bills. ■ Gearing (net debt/net asset value) must be less than 75 per cent, or net debt must be less than two times cash profits (Ebitda). ■ The company must pass at least one of Mr Dreman's two quality tests: having operating margins better than 8 per cent or a return on equity of more than 10 per cent. Companies qualifying based on our GV ratio must pass both tests. ■ Dividend cover of 1.5 times or more, or above the three-year average. ■ For low PE ratio and low P/CF stocks I've also applied Mr Dreman's test that dividend yield should be above the median average, which reflects the importance he attaches to yield in achieving returns. |
A total of 19 shares met the screen's criteria and they are arranged in order of highest to lowest three-month momentum in the table below. I've also taken a closer look at three of the shares showing strong three-month momentum. My write-ups below attempt to focus on the reasons for the shares' apparent cheapness:
CHEAP SMALL CAPS
| Name | TIDM | Mkt cap | Price | GV ratio | Fwd NTM PE | DY | PEG | P/BV | P/CF | Div Cov | FY EPS gr+1 | FY EPS gr+2 | 3-mth mom | Net cash/ debt (-) | Cheap |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Plus500 | AIM: PLUS | £749m | 652p | - | 9 | 9.0% | 1.0 | 9.4 | 8.8 | 2.8 | 18% | 4.1% | 62% | $156m | DY, PE |
| Interquest | AIM: ITQ | £32m | 88p | 0.4 | 7 | 3.4% | 0.7 | 1.3 | 5.4 | 2.8 | 17% | 12% | 8.1% | -£6m | PE, P/CF |
| Shoe Zone | AIM: SHOE | £105m | 210p | 0.6 | 12 | 6.2% | 1.5 | 2.9 | 10 | 2.4 | 7.9% | 8.4% | 4.8% | £14m | DY |
| Digital Globe Services | AIM: DGS | £20m | 68p | 0.7 | 10 | 5.3% | 1.6 | 2.3 | 4.1 | 1.3 | 122% | 13% | 4.6% | $1m | DY, PE, P/CF |
| Communisis | LSE: CMS | £94m | 45p | 0.5 | 7 | 4.9% | 0.5 | 0.7 | 4.6 | 3.4 | 16% | 6.5% | 4.2% | -£30m | DY, PE, P/CF |
| Manx Telecom | AIM: MANX | £241m | 213p | 1.0 | 16 | 6.2% | 4.5 | 2.8 | 8.3 | 1.7 | 11% | 6.2% | 2.1% | -£57m | DY |
| Novae | LSE: NVA | £559m | 890p | 1.3 | 11 | 5.6% | 3.6 | 1.6 | 7.1 | 3.2 | 3.4% | 2.7% | 1.5% | £60m | DY |
| Alumasc | LSE: ALU | £63m | 178p | 0.8 | 9 | 3.4% | 1.7 | 3.7 | 8.2 | 2.2 | 4.5% | 8.8% | 0.8% | £1m | PE, P/CF |
| Air Partner | LSE: AIR | £40m | 395p | 0.4 | 13 | 5.6% | 0.9 | 3.0 | 33 | 1.3 | 14% | 17% | -1.3% | £13m | DY |
| Braemar Shipping Services | LSE: BMS | £126m | 430p | 0.6 | 12 | 6.0% | 3.6 | 1.2 | 38 | 0.9 | 21% | 4.2% | -2.5% | -£3m | DY |
| NewRiver Retail | AIM: NRR | £771m | 331p | 3.6 | 16 | 5.4% | 1.5 | 1.1 | 28 | 3.0 | 3.9% | 8.4% | -5.8% | -£286m | DY |
| ULS Technology | AIM: ULS | £36m | 56p | 0.6 | 13 | 3.3% | 2.0 | 5.2 | 24 | 2.7 | 28% | 2.7% | -11% | £3m | GV |
| Martinco | AIM: MCO | £30m | 139p | 0.4 | 14 | 3.9% | 0.6 | 4.5 | 19 | 2.0 | 43% | 17% | -14% | £2m | GV |
| Norcros | LSE: NXR | £103m | 169p | 1.2 | 7 | 3.3% | 1.6 | 2.0 | 6.0 | 2.7 | 8.0% | 8.0% | -15% | -£29m | PE, P/CF |
| Sirius Real Estate | AIM: SRE | £318m | 42p | 0.7 | 16 | 4.3% | 0.3 | 0.9 | 12 | 6.8 | 37% | 17% | -15% | -€244m | GV |
| Games Workshop | LSE: GAW | £162m | 505p | 0.8 | 13 | 7.9% | 2.5 | 3.2 | 6.6 | 1.1 | 5.6% | 4.8% | -15% | £8m | DY, P/CF, GV |
| Foxtons | LSE: FOXT | £439m | 160p | 1.0 | 12 | 6.9% | 1.9 | 2.9 | 11 | 2.5 | 4.0% | 9.2% | -18% | £26m | DY |
| Numis Corporation | AIM: NUM | £221m | 199p | - | 8 | 5.8% | 3.0 | 1.9 | 34 | 1.8 | 1.2% | 5.9% | -21% | £119m | DY, PE |
| Solid State | AIM: SOLI | £31m | 365p | 0.9 | 9 | 3.3% | 1.2 | 2.3 | 52 | 3.0 | 14% | 3.6% | -36% | -£4m | PE |
Source: S&P Capital IQ
