Cheap, quality small-caps

We ran a similar screen last year, which we have slightly modified, but the general principles are very similar. That screen, which identified six stocks that met its criteria, has delivered a total return of 35.6 per cent over the past year, compared with 19.6 per cent from the FTSE All-Share. It should be noted that, despite the focus on quality, the divergence between returns from the six stocks was quite marked (see table below). And the 15 per cent negative return from James Halstead illustrates one of the major issues with buying quality stocks, which is that they can be harshly punished if a strong track record looks as though it may be about to give.

Source: Datastream

To keep our focus on smaller companies we've only screened Aim stocks and constituents of the FTSE All-Small index. Our key criteria for assessing quality is based on return on equity - often described as the theoretical return from every extra pound invested in a company - and operating margins (see below).

In addition, we're borrowing from a method used by famed US investor John Neff to avoid both shares that look vulnerable due to overvaluation and those that look suspiciously cheap. This involves eliminating both the most expensive and cheapest quarter of stocks based on PE, which in practice means PEs below 7.3 and above 23.6. In addition to this, we are only interested in stocks that are cheaper than average based on our 'genuine value' (GV) ratio - below 0.87. This ratio attempts to compare an earnings-based valuation adjusted for cash and debt with the expected total return from a stock based on expected earnings growth and dividend yield (see formula box).

Five stocks passed our screen and all but one are current IC buy recommendations. Ordered by lowest to highest GV ratio they are:

Globo (GBO)

Mobile software company Globo is one of only two stocks from this year's screen that would have made the grade based on both the old and the new criteria. That's no surprise given the exceptional growth it is generating. Demand is especially strong for its GO!Enterprise business software, which allows users to access documents and programmes from multiple devices. A recent first-half trading update reported 133 per cent year-on-year revenue growth from this part of the business, while consumer orientated products CitronGO! and GO!Social also put in a strong showing with revenues up 22 per cent. Overall, first-half year-on-year revenues rose 51 per cent to €32m with profits said to be ahead of expectations. New sales channels opening up in the second half should help the momentum. Investment and working capital needs saw a drop in net cash in the seasonally-quieter first half to the end of June to €9.2m compared with the €14.2m end-of-year figure in our table. Despite the strong growth, the shares are on a bargain basement rating (last IC view: Buy, 8 Apr 2013, 41p).

*Based on EPS forecast for the next 12 months

**Based on companies' financial years

Source: S&P CapitalIQ

Brightside (BRT)

Motor insurance broker and financial service provider Brightside, which recently recieved a preliminary bid approach at 27p, has spent much of its time since listing integrating the businesses that were brought on board by its founders. Despite the focus on moulding businesses together, the company has achieved an impressive record of revenue and underlying profit growth. Indeed, analysts at Edison Research calculate compound annual growth rates since 2008 - when the company came to Aim - to be 29 per cent and 32 per cent respectively. The company is also focused on growing online sales and serves a number of big-name clients, such as Asda, through its affiliates business. However, Edison is less optimistic than the consensus EPS growth figures quoted in our figures. While reported profits should benefit from the elimination of non-cash integration costs from past years, Edison expects underlying earnings growth to moderate for the next couple of years due to the pressure from falling premium rates and the cost of winning more online business. However, the research house also sees the potential for good policy growth from the more streamlined business. What's more, a forward PE ratio of 8.5 can hardly be described as demanding (last IC view: Buy, 22 Apr 2013, 25p).

RWS Holdings (RWS)

Specialist translation services business RWS is producing solid growth based on market growth, market share gains and acquisitions funded by its strong cash generation. Recently, growth has been strongest from the companies patent translation business, which accounts for over 70 per cent of revenues. The operation has been substantially pepped up by the strong performance of Inovia, the world's largest non-law-firm provider of international patent filing solutions, which reported 27 per cent revenue growth in the first half. RWS has initially bought just a third of the company, but has an agreement to buy the rest this September for a maximum of $25.4m should the business have achieved sales of over $29m and cash profits of $5.4m in the year to the end of June. The multiples applied to RWS's shares, even after accounting for cash, are punchier than those of the other stocks on our list, but there are good grounds to argue that the business's quality and prospects justify them (last IC view: Hold, 10 Jun 2013, 710p).

e2v Technologies (E2V)

Like many companies in the electronics industry, radio-frequency, microwave and semiconductor products group e2v has had a tough time of late. Torrid trading in Europe and defence cutbacks have hurt and the group was forced to warn twice on 2012 profits. However, while profits fell last year, there are hopes that 2013 will see the group move forward despite a slow start. Indeed, at the end of June, the order book was up 41 per cent at £192m. What's more, only a quarter of the company's work is now in the defence sector and last year nearly three-fifths of its sales came from outside Europe. So modest progress is expected this year and next, which, along with a strong balance sheet, makes the modest forecast earnings multiple of 11 and reasonable yield look attractive for investors prepared to wait for some cyclical upside (last IC view: Buy, 20 May 2013, 129p).

Tracsis (TRCS)

Tracsis provides software and technology to make transport more efficient. It has very high penetration in its core UK rail market and prospects should be helped by a busy period of bidding for rail franchises through to 2018. Introducing new products and upgrading clients is helping to fuel organic growth. With the help of acquisitions the group has also been moving into other areas of the transport market, such as road. Plans to boost infrastructure spending as a way of pepping up the economy bode well on this front. Meanwhile, the acquisition of a fellow Aim-listed company called Sky High in April has given it an office in Australia, which could herald the beginning of the group's international expansion. The group also boasts a good record on earnings-enhancing acquisitions, which adds to the growth potential. Considering the net cash position, which broker WH Ireland forecasts to be at £6.4m at the year-end despite the Sky High purchase, the shares' rating looks far from challenging (last IC view: Buy, 28 Mar 2013, 187p).