Five high-growth small caps

As well as his stringent stock-picking criteria, Mr Zweig also put a lot of focus on market timing. His approach can effectively be summed up with two well-known investor sayings: "The trend is your friend" and "don't fight the Fed". While Mr Zweig's 1986 book 'Winning on Wall Street' set out in some detail the indicators he used to make decisions on how much market exposure to have, it's clear that both the recent market falls and expectations of monetary policy tightening can be regarded as generally negative factors. Nevertheless, there are good grounds to believe that Mr Zweig's stock-picking approach is able to produce strong outperformance regardless of the investment backdrop.

The Zweig-inspired small cap screen I ran last year put in a decent run (see table), but the return it produced was not a knockout one in the context of the strength of the market as a whole. Indeed, while the screen's 25 per cent total return comfortably beat the 11 per cent achieved by the Aim All-Share index, from which five of the six stocks selected came, it was inferior to the stunning 35 per cent from the FTSE Small Cap index over the same period. And, while the screen picked some big winners such as soft drinks company Nichols, it also alighted upon one big loser in the form of Zytronic.

Source: Datastream

I've slightly tweaked the screen criteria this year to put a bit more emphasis on high recent growth rates. The criteria is as follows:

■ A five-year EPS compound annual growth rate (CAGR) of 15 per cent or more

■ A five-year revenue CAGR of at least half the five-year EPS CAGR

■ EPS growth in last year of 15 per cent or more

■ EPS growth in last half year of 15 per cent or more

■ EPS growth in each of the last three years and at least four of the last five years

■ EPS growth in each of the last two half year periods

■ Net debt to cash profits of 2.5 times or less

■ A PE ratio above the lowest 10 per cent of all stocks and below the highest 20 per cent.

Five stocks passed the screen and below they are listed from highest to lowest five-year EPS CAGR:

Craneware

While hospital-billing technology company Craneware (CRW) may boast the best five-year earnings growth rate of our five stocks, it has the least impressive forecasts for growth. Indeed, brokers have been paring back their EPS expectations for some time and the most recent downgrades followed a profits warning in July.

The group is mainly focused on selling to US hospitals and for some time reforms to the healthcare market have meant tough trading conditions. This should have eased by now and, indeed, the group has been making good progress with its business focused on direct sales. The key problem, though, is that it has failed to secure large deals through third parties. Some of this is down to corporate action among its partners, but it is nevertheless a worrying trend which has been the source of major downgrades.

That said, third-party sales tend to be lumpy but significant and, following recent disappointments, any future wins are not factored into most broker forecasts. Analysts at N+1 Singer believe there are still about nine deals in the pipeline which could mean some positive surprises if any are won. Meanwhile, once reporting on the recent annus horriblis is out of the way - preliminary results are expected this month - it should be possible to put a renewed focus on the direct sales business which analysts' expectations are now based upon. N+1 predicts that, following a 9 per cent drop in EPS in the year to the end of June 2013, the company will achieve growth of 7 per cent in the current financial year followed by 11 per cent in 2015. Management is judged to have done a good job keeping costs under control during recent testing times. Craneware therefore looks like less of a classic Zweig stock, but an interesting recovery/growth play, nevertheless.

Source: S&P Capital IQ

*Based on consensus forecast for the next 12 months

Last IC view: Buy, 395p, 26 Feb 2013

Solid State

Specialist electronics distribution and manufacturing company Solid State (SSP) has achieved its strong track record by focusing on niche markets. Specifically, the company supplies ruggedised computers, electronic components, antennas, microwave systems and battery solutions. The company stands to benefit this year from its May acquisition of Q-par which is reported to be integrating well. And the acquisition itself helps illustrate a strategic shift by the group away from its traditional distribution business into higher-margin niche markets. This is helping to increase order visibility as well as margins.

The company started the year with a healthy order backlog of £10.4m and at the time of its AGM last month, reported that "order intake remains strong and margins are holding up well". While broker WH Ireland expects sales to dip this year by £500,000 to £31m, this is the result of some large one-off orders in the year to the end of March 2013, and improved margins are expected to push earnings ahead nicely despite these lower revenues - WH Ireland's forecast is for about 7 per cent growth. What's more, the attractive dividend is predicted to continue to show strong growth rising from 8p to 8.5p this year and 9p next, giving a forecast yield of 3.6 per cent increasing to 3.9 per cent.

Last IC view: n/a

Brooks Macdonald

One of the factors that investors need to take account of when investing in growth businesses is that, from time to time, they can require significant investment to keep growth rates up. That will be the case for wealth management company Brooks Macdonald (BRK) in 2014. Indeed, while strong growth is forecast for the yet-to-be-reported financial year to the end of June, the consensus forecasts for the following year listed in the table below appear to be behind the times. That's because management has said that a combination of increased spending on IT and changes to charging on pooled funds is likely to keep profits flat in 2014. So following expectations of a 34 per cent increase in EPS in the year to June 2013 to 76.6p, broker Numis is pencilling in a fall to 75p in 2014.

But the stagnation in EPS growth is expected to be only temporary. Indeed, the company is attracting new funds at an impressive rate, even though the introduction of the retail distribution review (RDR) has caused some disruption. The company continues to target organic growth of 20 per cent and the costly changes being made this year should help it to realise this ongoing ambition. The shares have slumped in response to recent events, but in the absence of any further negative surprises sentiment may well improve as the focus switches to the 2015 financial year once the full-year results, scheduled for 11 September, are out of the way.

Last IC view: Buy, 1,316p, 13 Mar 2013

Dart Group

A move into the package holiday market, using its Jet2 brand, has been powering exceptional growth at airline and logistics company Dart Group (DTG) for a number of years. Holidays are an excellent business for the company as it allows it to get cash upfront and also provides stronger revenue visibility. Indeed, the net cash figure reported in the table below includes £253m of advanced customer payments. But perhaps most importantly, demand for its budget package holidays is rampant. Last year it almost doubled the number of Brits it took overseas, holiday profits jumped from £2.5m to £6.8m, and bookings remain strong.

The company has been investing in expansion and fleet modernisation which should underpin prospects and help it achieve its objective of once again doubling the number of holidays sold this year. Its other businesses in budget flights and logistics have also been performing solidly providing a sound backdrop for the break-neck growth of Jet2. Given the nature of the business, though, recent rises in the oil price due to Syria-related concerns are an issue.

Last IC view: Buy, 240p, 19 Jul 2013

Advanced Medical Solutions

The forecast EPS growth rates in our table somewhat understate the potential of wound care specialist Advanced Medical Solutions (AMS). That's because, while broker Investec predicts revenue will grow 9 per cent this year and cash profits will be up 10 per cent, an increased tax charge will mean this underlying progress will have a limited effect on the bottom line and therefore reported EPS.

This issue aside, though, it seems fair to continue to describe AMS as a growth stock. But the company does face some issues. It had a bumper 2012 thanks to acquisitions and product launches, which has set it a high bar to beat this year. What's more, a third party distribution agreement with Cardinal Health in the US for its Liquiband product has proved disappointing. While a trading update in June suggested the distributor was reordering from AMS, the company may have to take action over the arrangement which could prove costly. The June update, ahead of the imminent half-year results, was broadly encouraging, though, and a new product launch in the second half should boost sales.

Last IC view: Hold, 72p, 6 Mar 2013