Quality small caps at reasonable prices

The stock screen we ran a year ago has substantially outperformed the market, delivering a 20.7 per cent total return compared with 15.1 per cent from the FTSE All Share. The result was even better from our six preferred stocks from the screen - those with a PEs of between 10 and 20 - which produced an average total return of 32.4 per cent. We'll re-run the large-cap screen next week - but this time around it is all about smaller companies from the FTSE All-Small and the FTSE Aim 100.

We've carried out a bit of fine tuning on our large-cap screen in order to generate a decent amount of small cap results. Return on equity (RoE), often regarded as the return investors can expect from every fresh pound invested in a company, continues to be our primary measure of 'quality'. However, while our large-cap screen was fairly arbitrary in it where it set its threshold for quality (a RoE of 17.5 per cent or more). This time we are concerned with companies which boast a high RoE compared with their peers. So we're requiring that a company has an RoE in the top quartile; in practice. Actually the 17.5 per cent figure is not a bad proxy for what constitutes a top-quartile performance as a top-quartile RoE ranged from 14.9 per cent to 17.4 per cent over the year's we've looked at. The other measures our screen uses to gauge a company's prospects have also now linked to the average performance of the sample group rather than the more arbitrary limits of our large cap screen.

We've also put more emphasis on value with this screen. The measure we've used to value the stocks in our screen is a forecast P/E ratio adjusted to factor in a company's net cash or net debt position. Balance-sheet strength is often overlooked by the market but given its importance in funding growth we want our screen to take account of it. Our chosen valuation measure is in fact quite similar to the earnings yield used by investment legend Joel Greenblatt (pictured below) in his 'magic formula'.

Given that we're looking at high-quality stocks, the main valuation risks are either that the market is already factoring in so much good news that there is little upside, or that the rating is so low it suggests all is not what it seems based on the fundementals. We therefore are only interested in results outside either the bottom or top quarter of the valuation range. The other factors we've looked for are:

The only stock to pass the quality criteria of our screen but fail the valuation test was Abcam, which made a strong contribution to last year’s portfolio. We’ve included a brief write up of the other stocks below.

RWS Holdings

source: S&P CapitalIQ

A relatively weak first-half result, economic headwinds and problems in a German business have all weighed against patent translation group RWS recently. But patent translation has proved itself relatively resilient in the past and the group has recently won a number of new contracts which help underpin its claims that the current financial year will be weighed towards the second half. The acquisition of US foreign-patent-filing business Inovia for £19.8m last October looks very shrewd; it's performing ahead of expectations. More acquisitions are possible, and based on the price paid by a private equity firm for rival CPA recently, it looks attractively valued.

Last IC View: Hold, 500p, 7 Jun 2012

SuperGroup

SuperGroup seems an odd stock to have made it through a 'high quality' stock screen as the problems that saw its shares halve in value over the last 12 months were largely of its own making. Accounting and supply chain errors were severely punished by investors who thought they were buying a growth story. New management says it has got a grip - although the share price suggests otherwise - and there's no doubt that on the high street, its Superdry brand is still popular with consumers.

Last IC View: Hold, 388p, 13 Jul 2012

James Halstead

Vinyl-flooring specialist James Halstead recently told shareholders to get ready for another record set of results when it reports on the year to the end of June. The company’s strong long-term track record, which includes increasing the dividend for each of the last 36 years, has been aided by its success in moving into new parts of the market and new geographies - it now generates two thirds of its sales from outside the UK. Halstead's impressive credentials earned it a place in our high-quality screen a year ago and it contributed an impressive 41 per cent return, leaving the shares only just outside the most expensive quarter of shares based on our valuation measure. Nevertheless, some good things are worth paying for.

Last IC View: Buy, 585p, 1 Aug 2012

Brooks MacDonald

Wealth management firm Brooks MacDonald has built a tremendous track record since it came to market in 2005 and the company is currently benefiting from the growth of self invested personal pensions (Sipps) and changes in the regulation of financial product sales. On top of these tailwinds, the company should reap the benefit of recent investment in its own business, including a new office opening, the establishment of a fund management operation and the building of a state-of-the-art back office which will be able to take on work from third parties as well as processing the group’s own business. True, the shares are not cheap, but that has done little to hinder their performance in the past.

Last IC View: Hold, 1,345p, 13 Mar 2012

Andor Technology

Andor, a maker of specialist high-tech cameras used in research and development, came a cropper earlier in the summer after it was forced to issue a profits warning following the cancellation of two big orders worth about £3m. That disappointment aside, Andor is a leader in its field and is focused on pushing its products into new markets, such as aerospace. Analysts still expect modest sales growth this year despite the lost orders, while the EPS rise in the next twelve months is based on predictions of a fall this year followed by a strong bounce back in 2013.

Last IC View: Buy, 389p, 11 Jun 2012

Nichols

It has taken the market a long time to wake upt to the charms of soft-drink maker Nichols, but following three years of stellar share price performance its share rating is close to the top end of the range for passing our screen. The soft drink company faces some headwinds this year, such as rising raw materiall prices and a soggy UK summer. But things looked to be on track at the time of interim results, while the combination of low UK market penetration and strong growth in the Middle East is attractive.

Last IC View: Buy, 693p, 26 Jul 2012