The market is prone to pushing stock valuations to extremes of euphoria and despair. In no part of the market is this truer than with small caps. A lack of interest from large investors means these shares are under-researched and the sensitivity of the underlying businesses to swings in trading means sentiment can play a key role in determining share ratings.
This week we went looking for shares whose valuations are at the despair end of the range. To be precise, we want stocks that are trading at a discount to tangible book value of 25 per cent or more, or 40 per cent in the case of investment companies (that's a P/TangBV below 0.75 or 0.6 for investment companies). We also want to see signs that these companies have a viable business. We label these shares as special situations due to the apparent discount to tangible assets and the potential for returns to come from the underlying business – some of the companies in our list even pay dividends. But it is rare in life that one really gets something for nothing and that is certainly the case with our screen. The something investors have to take with these stocks is a lot of risk.
Given the nature of the screen, it's perhaps not too surprising that the results look like something of a rogue's gallery. That’s not to say there isn't considerable potential upside to be had from some of these shares, but this screen is definitely one that we’d regard as a starting point for further research rather than an off-the-shelf portfolio to buy. What's more, it should be remembered that unlike Benjamin Graham's famous Net-Net criteria which looks for companies valued at less than their easily realisable assets, a companies tangible assets can be hard to dispose of. This is a key factor behind the big discount of Local Shopping Reit (see below) and it would be hard to disentangle Pure Wafer and Steppe Cement (two of our other screen results) from their operational assets. In addition, balance sheet valuations of assets can often be found to be wanting at times of distress.
We've used a series of basic tests to try to eliminate the very worst dregs from our screen. These tests are designed to look for signs that a company may have a credible underlying business and that sentiment (measured by 3-month price momentum) may be improving toward the shares. So in addition to low P/TangBV we have tested all stocks in Aim and the FTSE All-Small index for:
■ Rising underlying earnings based on EPS for the most recent half year (H0) plus EPS H-1 compared with EPS H-1 + EPS H-2.
■ A current ratio of more than 1
■ Positive free cash flow last year
■ 3 month share price momentum greater than the 3.8 per cent from the FTSE All Share (we’ve published a list of stocks failing this test but passing the other tests below).
SIX SMALL CAP SPECIAL SITUATIONS:
