UK small caps have had a rollercoaster ride so far in 2009. After first plumbing new depths in the spring, shares in smaller firms had enjoyed eight months of solid rises by the time winter arrived.
In early March London's Alternative Investment Market, home to more than a thousand small cap companies, hit a low of 373.76 points. But by November this year it had climbed 81.7 per cent to reach 679.27 points. Meanwhile, two other small cap indices, the FTSE Small Cap and FTSE Fledgling, both increased by more than 80 per cent respectively over the same period.
So what now for small caps? If this decade's booms in other asset classes are anything to go by they might enjoy further rises to beyond past peaks in terms of price-to-earnings ratios. However, one must remember that share prices are linked to the expected performance of the economy and UK small caps are generally linked to the performance of the UK’s economy, which is not yet out of the woods.
Sometimes it is useful to look at what the companies themselves are saying about their prospects. So, with this in mind, we have conducted a survey of November trading updates and interim management statements from small cap companies listed on the FTSE AIM, FTSE Small Cap and FTSE Fledgling indices. This revealed a poor(ish) outlook for small cap shares.
Stripping out statements from investment trusts and property investment companies, we found that 107 listed businesses reported trading in line with market expectations. There were 21 profit warnings, while just 19 firms had statements that could be interpreted as being upbeat.
Perhaps most telling is that larger companies had fewer profit warnings and more upbeat statements. The FTSE Small Cap index, which typically includes small cap firms that have market valuations in excess of £100m, had just four profit warnings compared with seven upbeat statements. By contrast, the FTSE Fledgling index had six profit warnings compared with only two upbeat statements.
This is not so surprising, since large firms tend to do better than small companies during recessions thanks to their economies of scale giving them greater bargaining power with their suppliers and customers, as well as better lines of credit with their banks.
Our findings suggest it is probably not a great time for investors to jump into small caps. Profit warnings tend to be followed by poor results and further profit warnings, so holding off until further bad news comes in the spring of 2010 is likely to be the best strategy for investors who favour smaller firms.
However, for those who are not prepared to wait, here we profile six companies for those investors looking for small cap opportunities now.
Alliance Pharma is a specialist pharmaceuticals business that focuses predominantly on niche prescription brands. The focus on prescription drugs means a stable revenue stream, while the fact that Alliance has a portfolio of almost 40 of these brands means that it is not overly dependent upon any one product for its overall revenues.
The AIM-quoted company's business model involves the acquisition of prescription medicine brands "that have stood the test of time". To Alliance Pharma, this means brands that have a long history of sustainable sales where demand is largely unaffected by the economic cycle; on average, the medicines it sells have been around for 40 years.
A key benefit of owning longstanding, proven prescription brands is that Alliance Pharma does not need to invest in sales support for many of the medicines in its portfolio. Sales of these medicines have remained stable, and have even increased, so that the company can focus its marketing effort on brands where it sees greater opportunities for growth.
Another key part of the company's business model is its focus on niche brands, rather than generic drugs. This means it avoids price competition from the very large pharmaceutical firms that exploit economies of scale to make money by manufacturing and selling low-margin, high-volume medicines.
In early November, Alliance Pharma reported that sales in the nine months to the end of September were up 44 per cent to £21.4m compared to the first nine months of 2008, and that if this strong performance continued for the remainder of the year pre-tax profits for 2009 would "significantly exceed" expectations. The company also reported that sales of two brands it acquired in August 2009, Buccastem (a treatment for nausea and vomiting) and Timodine (an anti-fungal skin cream), had been in line with management's expectations.
For 2009, Alliance Pharma is forecast to deliver revenues of £28.5m and pre-tax profits of £6.3m, which translates to earnings per share of 2.7p. After the update Alliance Pharma's shares increased by around 30 per cent to trade for around 23p each, but they should remain a buy at this price.
Packaging business British Polythene Industries is one of the largest producers of polythene film products in the world. The company makes films for a variety of sectors, but it also has an eye on the fast-paced legislative environment in which plastic industries operate, which has led it to produce films made from biopolymers as well as develop a major waste polythene recycling programme.
Operating in the UK & Ireland, Continental Europe, North America and Asia, the FTSE Small Cap firm has benefited in recent years from becoming increasingly well-diversified in terms of its geographical markets. Sales to mainland Europe currently account for approximately 27.5 per cent of overall turnover, while North American sales make up just over four per cent of the total.
After a tough 2008, the company reported in the summer that July had proved a much better month than it had been last year. According to an interim management statement issued in November, the trend continued during August, September and October and British Polythene now expects 2009's results to come in near the top end of current market expectations.
The company said it continues to benefit from the weakness of sterling against the euro, although its European business had seen increased competition from UK-based rivals.
In general, trading remains "challenging" but British Polythene said that, after some restructuring, its capacity and cost base was now better aligned to customers' demands and this had allowed it to reduce losses at certain UK sites that produce packaging for the depressed construction and industrial sectors of the economy.
The company is closing its Stockton site, and it has already moved some production from there to other locations. However, it currently has significant duplication of both people and site costs, so the full benefits of the closure will not start to come through until the second half of 2010.
Forecasts for the business suggest that although 2009 revenues will be lower than last year, earnings per share will come in 32 per cent greater at 33.7p. This puts the company’s shares on a rating of 8.5 times its earnings, which suggests they are on the cheap side despite their strong rise since the summer. Good value.
Investment Bank Collins Stewart is a FTSE Small Cap business that offers a wide range of financial services, including institutional stockbroking, corporate finance advisory services, debt capital markets advice, private client wealth management and asset management. With its main activities focused on Europe, the company also has offices in Asia and the US.
Unsurprisingly, the Credit Crunch and resulting economic downturn in the UK and elsewhere has not been kind to the financial services industry during the past couple of years. However, recent announcements from Collins Stewart suggest life is improving for investment bankers.
At the half-year stage the company reported that actions taken by its management team towards the end of 2008 and in early 2009 had led to a positive impact on the firm's results for H1 2009. Operating profit came in at £6.1m during the first half, compared with a loss of £2.5m during H2 2008.
Then, in an interim management statement released in November the bank reported that the positive momentum established at its businesses during the first half of the year had continued, with total revenues for the four months to 31 October being four per cent ahead of the same period during 2008. The firm traded profitably throughout those four months compared to producing a loss for the same period in the previous year.
Collins Stewart is forecast to produce earnings per share of 4.6p this year and 6.1p in 2010. Such growth suggests the shares – 75.5p each – are on the cheap side. Meanwhile, each share is expected to pay a dividend of 3p for 2009 and 2010.
With its headquarters in Scotland, FTSE Small Cap firm Devro operates worldwide as a manufacturer of edible collagen casings for the food industry. One of the most common forms of protein, collagen is transformed by Devro into strong, but flexible edible casings that are used for sausages and other kinds of foods.
Devro is fortunate to be operating in a global market that is continuing to grow, driven primarily by economic expansion and increased meat consumption in emerging markets. During the first half of this year, sales of Devro's products to the Americas (including Latin America) and the Asia/Pacific region accounted for 44.6 per cent of the company’s total sales, up from 41.4 per cent in 2008, although Devro's European sales still enjoy steady growth.
In November, the company reported "encouraging" recent trading compared with the first half of the year, with sales volumes in Latin America and the Asia/Pacific region continuing to show good growth. Devro also said that it would be investing in additional manufacturing capacity during 2010 in order to take advantage of the continuing growth in demand for collagen casings.
In the weeks following Devro's interim management statement, directors showed their faith in the company by buying an additional 64,000 shares at prices ranging from 122p to 129p.
Devro is forecast to improve revenues by 21 per cent this year to £221.4m while pre-tax profits are expected to be £23.4m (2008: £15.3m). Earnings per share are estimated to increase by 23 per cent to 10.1p. The shares, 128p at the time of writing, look good value.
Hardy Underwriting Bermuda is a Lloyds of London insurance business that underwrites aviation, marine and a broad range of non-marine risks on both a reinsurance and direct basis. Thanks to its location in Bermuda and a strong presence in the US, the FTSE Small Cap firm has direct access to two of the top three insurance/reinsurance markets in the world.
As well as offering traditional insurance services, such as commercial property cover, the company has a strong focus on covering niche insurance areas. For example, it offers helicopter insurance as well as cover for the transportation and storage of such items as fine art and classic cars.
Meanwhile, Hardy has specialist insurance lines covering events that might occur due to terrorism or political issues.
This year, as well as establishing its Bermuda office, Hardy has also created a joint venture in the Middle East, which it believes will give the company significant potential for business expansion in a rapidly-developing economy.
In November, the company reported that the period since August had been benign for catastrophe claims and that it had benefited from low insured loss activity during the Atlantic and Pacific hurricane seasons. Hardy also reported that it expects non-catastrophe exposed classes to return to strength over the coming year, which should mean significant potential for enhancing the value of the business.
Hardy is forecast to generate a pre-tax profit of £20.8m on revenues of £217m this year, with earnings per share coming in at 36.4p. Next year, EPS is expected to increase 34 per cent to 48.9p, suggesting that the shares – 292.5p each at the time of writing – are cheap. The company also pays a healthy dividend, which is expected to yield five per cent over the coming year.
Recruitment firms are not supposed to do well in recessions but Staffline Group, a recruitment and employee training firm with a focus on supplying temporary staff to industrial businesses, has seen turnover and profits hold up well during the past couple of years. Pre-tax profits did slip back at the AIM-quoted company last year to £3.4m (2007: £4.4m), but Staffline's broker Altium Securities expects an improvement this year to £3.5m after the firm issued an upbeat trading statement in November.
Despite market conditions continuing to be "extremely challenging" Staffline reported a more successful first 10 months of the year than its management had originally anticipated. Meanwhile, the company has made operational savings, including a headcount reduction of 20 per cent.
Staffline has also been acquisitive, having this year bought four businesses – Bridge Contract Services, The Workplace, La Gente and Peter Rowley – that are expected to add more than £12m in revenues to the group's turnover (£120.8m in 2008).
The most recent acquisition, in which Staffline paid £1.5m to buy Peter Rowley, is described by Altium as a complementary fit. Focused on training for 'lean manufacturing' into the food processing industry, Peter Rowley will augment the group's existing training activities and will allow the enlarged group to bid for large government-funded schemes, particularly those aimed at the long-term unemployed.
After this acquisition, Altium upgraded its estimates for Staffline during 2010. Pre-tax profit for next year is now expected to be £4.2m while earnings per share should improve to 13.3p against an EPS estimate for this year of 11.1p.
Meanwhile, Staffline's management is continuing to seek further acquisition opportunities, which, as Altium's analyst point out, signifies greater confidence by management in the end markets on which the group focuses.
