Five cheap, high-growth small-caps

While the PEG ratio (PE/EPS growth) does give another dimension to seeking value than the classic PE ratio, it still keeps things simple which is arguably one of its core strengths. While Mr Slater does talk about the importance of a dividend (not actually a criteria in our screen) and a robust balance sheet in The Zulu Principle, these factors are not worked into the PEG ratio unlike the measures used by other famous investors, such as John Neff. But what is lost in completeness, may be made up for in the fact that the ratio focuses on the valuation attributes that the market - rightly or wrongly - is most obsessed with. This has particular pertinence for small-cap investing where sentiment can play a big roll in determining performance.

Probably the most noteworthy emission in our screening criteria this week when comparing it with those set out in the 'Zulu Principle' is that we have not tested the earnings track record of the shares we’ve screened and have instead focused on consensus broker forecasts. Some parts of the Zulu approach are hard to screen for accurately such as Mr Slater’s requirement for a positive outlook statement and management ownership, but we’ve tried to consider these points in the write up of the companies that passed the screen below. The screening criteria we’ve used is as follows:

■ Value: A PEG ratio of 0.75 or less, based on either long-term consensus forecast EPS growth where available or the average forecast growth for the next two financial years.

■ Growth: Average forecast growth for the next two financial years of more than 15 per cent but less than 50 per cent.

■ Size: Mr Slater's view of larger companies is that "elephants can’t gallop." We therefore have set a market cap limit of £250m and are also excluding companies with market caps below £20m.

■ Competitive advantage: A return on equity of more than 12.5 per cent or operating margins in excess of 15 per cent.

■ Sentiment: Three-month price movement greater than the median average.

■ Cash conversion: Operating cash flow equivalent to 90 per cent or more of operating profit.

■ Finances: Net Debt of less than 1.5 times cash profits.

Our write-ups of the five stocks that made the grade below try to encompass some of Mr Slater’s key "Zulu Principle" ideas, such as a focus on strong balance sheets, optimistic outlook statements, director ownership and dividend payments.

NWF

Farm feed, fuel and food business NWF (AIM: NWF) recently told the market to expect it to report much stronger full-year results than were previously being forecast. But management’s glee had to be tempered with an explanation that much of the improvement was down to the cold winter which had boosted fuel orders and meant animals had been kept inside for longer which increased feed demand. Indeed, rather than the smooth earnings progression that brokers expected before the cold winter, EPS may well actually fall in 2014 if more normal weather prevails. However, while NWF is somewhat at the mercy of the elements, it does also boast underlying growth drivers. The efficiency of its operations gives it an advantage over competitors while a recent emphasis on improving service levels is also helping to drive stronger performance, but results from the food business have recently proved somewhat disappointing.

NWF boasts a decent dividend yield which fits well with the Zulu criteria and forecasts are for dividend growth of about 5 per cent a year. A strong 2013 should also help bolster the balance sheet with gearing down to 50 per cent at the half year. Mr Slater was also interested in asset value and broker Peel Hunt highlights the value in the group’s asset in Wardle which is worth about £30m. NWF’s strong growth forecasts in part reflect a dip in earnings in 2012, nevertheless the shares do boast virtues as an undervalued-growth situation.

Source: S&P CapitalIQ

*Based average consensus growth forecasts for the next two financial years

Last IC view: Hold, 120p, 30 January 2013

NetplayTV

NetPlay's (AIM: NPT) business of offering casino games through the TV and increasingly over mobile devices is powering extremely strong growth. The company is extending the number of nights it broadcasts through Channel 5 and ITV from four to six and has also recently been boosting its marketing spend. The brand and the TV channel relationships do help give NetPlay the kind of competitive advantage Mr Slater is keen on. Despite the increased marketing costs, margins are rising and cash conversion is strong. From the Zulu perspective, net cash and an expected 2013 yield of 2.4 per cent based on broker Daniel Stewart’s forecasts both tick the box.

The most recent outlook statement from the group was very encouraging with depositing players up 42 per cent year-on-year in the first quarter and mobile-devices accounting for 34 per cent of new players compared with 12 per cent in the same period last year. The group also expressed optimism about its attempts to diversify revenue. On the downside, there has recently been selling by non-executive director Andrew Lapping who offloaded 3.3m shares at 16.9p a pop leaving him with 8.9m, or 3.1 per cent of the company. That said, chief executive Charles Butler bought 410,000 shares at 11.5p at the end of last year taking his holding to 2m.

**Based on long-term consensus forecasts

Last IC view: Buy, 17.8p, 9 April 2013

Avon Rubber

A programme of investment in new products and markets appears to be really paying off for gas masks and filters specialist Avon Rubber (AVON). The virtue of management’s strategy was brought home in the first half when, despite the weakness of the milk market into which it sells filters, the group reported a 20 per cent jump in revenues thanks to the strong performance of its core defence and protection division. What’s more, the order book was up by a tenth to £40m. The group invested 6 per cent of revenue during the half and analysts at Edison believe the spending is putting the group on a sustainable growth path which will power a 16 per cent plus compound annual EPS growth rate over the next two years. Improvements in the US economy should also help the group as over four-fifths of sales are in the region.

While the dividend yield is not one of note, strong dividend growth is forecast. And the balance sheet looks good with gearing of just 32 per cent at the half-year stage while first-half cash conversion came in at an impressive 132 per cent. There has been little action on the directors dealing front over the past year outside share awards and share save plans, but no selling. Management’s mood about the future definitely looks optimistic based on the half-year results statement with confidence even being express in the group’s position in the trying milk market where management feel there is potential for a pick-up.

**Based on long-term consensus forecasts

Last IC view: Hold, 432p, 1 May 2013

Terrace Hill

Property developer Terrace Hill (AIM: THG) may seem a bit of an odd company to have made it through an earnings-based growth screen as the key focus for most investors will be its assets rather than its earnings. Nevertheless, the shares look achingly cheap compared with peers at the moment trading at a 35 per cent discount broker Oriel Securities’ 31p NAV forecast for the year. What’s more, the group has made substantial headway reducing net debt with a fall of £36.8m in the first half to £10.2m, or £17.9m including joint ventures, thanks to the sale of much of its residential portfolio. Meanwhile, the earnings-growth forecasts that have earned the shares their place in our screen are an indication of its improving development success. In the first half the group completed three supermarket projects and forward sold a student flat development in Southampton. The company also looks like it is through the worst of a long period of land value write downs.

Having overhauled the books, management appear in confident mood. The group’s executive chairman owns over 60 per cent of the company which means his interests should certainly be aligned with shareholders. What’s more, the group’s focus on supermarket and student accommodation development leaves it looking well placed so the days when the shares traded at a premium to NAV may not need to remain as distant a memory as they have seemed over recent years.

*Based average consensus growth forecasts for the next two financial years

Last IC view: Buy, 20.5p, 5 Jun 2013

Record

Currency asset management specialist Record (REC) has recently started to return to growth reporting net inflows of assets under management last year which ended five years of outflows. The company also managed to bag three extra clients in the period taking the total number to 44. What’s more, the recent increase in currency volatility may boost demand for its hedging products. While the increased sales seen recently have been in lower-margin products, the improved performance is expected to feed through to profit growth in the coming year. Also management believe the product mix and margin have now stabilised. Profits should also be helped by a recent cost reduction programme.

While the forward PE ratio currently boasted by the group looks more or less in line with peers the net cash is of note as it accounts for about two-fifths of the group’s market cap. From the directors dealing perspective, a negative factor is that former finance director Paul Sheriff was selling shares at 31p at the end of last year, before leaving the company.

*Based average consensus growth forecasts for the next two financial years

Last IC view: na