Genuine value small caps

Genuine value small caps

Source: S&P Capital IQ

The performance of the screen is particularly pleasing as it gives so much onus to the ratio - the screen also attempts to filter out rogue results by ignoring suspiciously high and probably unsustainable growth forecasts, as well as stocks showing poor momentum.

As mentioned, the genuine value ratio is basically a price-to-earnings-growth (PEG) ratio with a few add ons. As well as looking at a stock's valuation against its profits and forecast earnings growth rate - as a PEG ratio does - the ratio also takes account of dividends paid and whatever cash and debt there is on a company's balance sheet. While I believe this approach covers more basics than a number of other popular valuation metrics, it's fair to say the ratio remains a rather rough-and-ready way to analyse stocks. It is therefore somewhat surprising, to my mind, that the outperformance generated by the 21 stocks selected by the screen last year has been quite disaster-free as it has.

The lack of true dogs in last year's screen could be down to the strength of small caps in general over the period, but it is nevertheless noteworthy that 17 of the 21 stocks (81 per cent) outperformed both the FTSE Small Cap and the Aim All-Share. And of those that underperformed, there were no total catastrophes. In fact, the worst performing stock (Getech) turned in a painful but relatively palatable negative total return of -9.3 per cent (see table).

Source: S&P Capital IQ

The ratio

This is how the 'genuine value' ratio is calculated.

The ratio uses enterprise value (EV) rather than market cap or price in order to reflect the cash and debt held by the company. Cash is taken off a company's market cap (to reflect its value to shareholders) while debt is added on (to reflect the claim lenders have on the company). While I am a fan of using EV, it does have its weaknesses as it only reflects a certain type of liability - debt.

Why is this a problem? Well, if, for example, a retailer leases property to boost earnings with new store openings, EV will not reflect the future rental liabilities that the company faces but earnings will still rise. If the same company decided to buy the property, EV would drop because funding the purchase would cause net cash balances to fall and/or debt to rise. In the first case, EV would not reflect the long-term costs of boosting profits, in the second case, it would. Therefore, the crude EV/ebit analysis would make the leasehold model look more attractive, which is a very dubious conclusion. Other liabilities such as pension deficits are also not reflected by the measure, and certain types of businesses need to hold significant amounts of cash due to the nature of their work - for example, Dart - selected for a second year by the screen - takes payments upfront for the package holidays it sells, which boosts reported cash.

Operating profit (ebit) is used in the ratio because earnings need to be looked at before any interest is paid on debt or received from cash held. This is important because if we are adjusting a company's value for debt and cash, we need to adjust earnings to take account of the cost or benefit associated with the debt or cash. Ideally, the ebit figure would be adjusted to take account of the company's tax rate as well, but I haven't found a satisfactory way of doing this.

The bottom half of the 'genuine value' ratio tries to look at the earnings growth and yield that will drive shareholder returns, although earnings multiples will adjust as sentiment towards a stock changes. This combination of growth and dividend is also used in the dividend-adjusted PEG ratio which has been popularised by the screening approaches of famed US fund managers John Neff and Peter Lynch. The difference with these metrics is that they use a price-to-earnings (PE) ratio instead of adjusting for cash with EV/ebit.

The Screen

The Genuine Value Small Cap screen itself starts by selecting the cheapest quarter of all stocks from the Aim and FTSE All Small indices based on the genuine value ratio (0.72 or lower). It should be noted that only a minority of stocks (463 out of 1,202, or 39 per cent) have the necessary fundamentals such as positive earnings and broker forecasts for the ratio to be calculated, so the mere fact that the ratio can be calculated for a small cap acts as something of a quality test in itself. While this screen gives a lot of prominence to the genuine value ratio, I do have a couple of supplementary criteria to try to overcome some of the ratio's major potential shortcomings. These are:

Suspect growth

Very high earnings growth is rarely sustainable for long, and high earnings growth based on a fleeting recovery in earnings from a very low base is also of little long-term value. As my genuine value ratio only looks at forecasts for EPS growth for the next two financial years, it can quite easily assign undue significance to this kind of short-term gain. Therefore, the screen uses two tests to limit the risk of putting too much emphasis on very high short-term EPS growth. Firstly, any stock where earnings are expected to double in either financial year is eliminated. In addition, any stock where the EPS growth rate is expected to drop by more than half between the two forecast financial years is eliminated

Suspect forecasts

Forecasting growth rates for small companies can be a very tough job. What's more, as is characteristic with all forecasts, analysts have to largely rely on events rather than speculation as the ground on which to adjust their numbers. This means unreliable forecasts can often remain in the market for some time despite creeping evidence that trading is getting worse. To test whether the market is buying into the investment case suggested by a low genuine value ratio, I use a simple momentum test. All stocks selected by the screen must boast better three-month momentum than the median stock out of the 1,202 small caps screened - in the case of this year's screen, shares must be up by -3.3 per cent or more.

Last year, I singled out the five cheapest stocks from the screen to write up. The performance of the top five stocks from last year does not suggest this necessarily is a very valid way of looking at performance as a lot of the best-performing stocks were those that were the most 'expensive' of the selected 'cheap' shares. I'm therefore simply presenting a table of this year's 20 Genuine Value Small Caps:

Source: S&P Capital IQ