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Three Genuine Value Small Caps

Last year's Genuine Value screen highlighted a number of pitfalls with small-cap investing, but the screen still boasts a strong longer-term track record with a 45 per cent total return over three years compared with 15 per cent from a blend of the FTSE Small Cap and Aim All-Share.
June 9, 2016

My Genuine Value screen's mission is to identify companies that offer investors the potential to buy into an earnings stream on the cheap. However, the earnings numbers that companies report and brokers forecast are not always all they seem, especially when it comes to smaller companies. This proved to be a major issue for my genuine value small-cap screen last year which underperformed the market with a negative 5.9 per cent total return compared with a negative 1.7 per cent from a 50:50 combination of the FTSE Small Cap and Aim All-Share indices.

 

2015 PERFORMANCE

NameTIDMTotal Return (22 Jun 2015 - 31 May 2016)
Highland GoldHGM79%
Lifeline ScientificLSIC60%
Dart GroupDTG58%
EmpresariaEMR33%
MartincoMCO29%
H&T GroupHAT20%
Sirius Real EstateSRE17%
RTCRTC8.8%
CarcloCAR4.8%
Morgan SindallMGNS4.1%
Hayward TylerHAYT-1.5%
City of LondonCLIG-1.6%
Liontrust Asset ManagementLIO-6.5%
SthreeSTHR-8.7%
Robert WaltersRWA-13%
MatchtechMTEC-19%
NAHLNAH-20%
Red24REDT-26%
CrestonCRE-32%
OPG Power VenturesOPG-35%
UtilitywiseUTW-41%
MothercareMTC-47%
Gulf Marine ServicesGMS-55%
Solid StateSOLI-56%
GloboGBO-100%
Genuine Value Small Caps--5.9%
50:50 Small Cap/Aim--1.7%
FTSE Small Cap--0.6%
FTSE Aim All-Share--2.7%

Source: Thomson Datastream

 

The problems encountered by several of the big losers from last year's Genuine Value screen typify common pitfalls associated with relying on earnings-centric equity analysis. The stand-out loser from the 2015 screen was Greek mobile technology company Globo. During the 12 months it transpired that much of the company's profit and loss account was simply a work of fiction. Trading in the shares was suspended in October last year when the board was alerted to "certain matters regarding the falsification of data and misrepresentation of the company's financial situation".

A much less grievous, but nevertheless damaging case of ambitious accounting was behind the disappointing performance of Utilitywise shares. Shareholders became perturbed by the utility consultancy group's practice of booking much of its sales and profits from long-term contracts upfront based on estimates of the cash flows it may receive over several years. The disconnect this caused between profit and cash flow led to a share price slide and new management are now trying to align cash collection with the reported profits.

Solid State illustrated another common problem for small companies: over-reliance on one large customer. The customer in question was the ministry of justice (MoJ) which earlier this year pulled the plug on a £34m prisoner-tagging contract with the specialist electronics group. Worse still, such was the investor excitement about the MoJ contract that the share's valuation reflected speculation that Solid State could use it as a shop window to bid for other large chunks of work.

But, while the past 12 months may have highlighted some of the weaknesses of this screen, the cumulative performance generated by the Genuine Value Small Caps over the last three years still looks impressive. The total return stands at 44.5 per cent compared with 14.9 per cent from a 50:50 FTSE Small Cap/Aim mix. Add in a 2.5 per cent annual charge to reflect the high dealing costs associated with small caps and the total return drops to 34 per cent.

 

Genuine Value Small Caps

 

The screen itself is very simple and focuses on a version of a price-to-earnings-growth (PEG) ratio I rather portentously call a "genuine value" ratio. The ratio tries to take account of the net debt or cash position of a company, as well as dividends and earnings growth. The formula is:

Enterprise-value-to-operating-profits (EV/EBIT) / Dividend yield (DY) plus average forecast earnings growth for the next two financial years

As well as a low genuine value ratio, the screen looks for shares showing good price momentum, and earnings forecasts that do not look too outlandish or inconsistent from one year to the next. The full criteria are:

■ Genuine value ratio among "cheapest" quarter of all stocks screened

■ Better than median average three-month share-price momentum

■ Forecast growth of less than 100 per cent in each of next two financial years

■ Growth rate must not be forecast to drop by more than 50 per cent between FY+1 and FY+2

Sixteen shares from the 1,210 stocks in the FTSE Small Cap and Aim All-Share passed the screen's tests this year and fundamentals relating to them are presented in the table below, which is ordered from lowest to highest genuine value ratio. I've also taken a closer look at three of the stocks choosing one of the relatively more expensive stocks, a mid-ranking valuation and a real cheapy.

 

GENUINE VALUE SMALL CAPS

NameTIDMMkt CapPriceGV RatioFwd NTM PEDYPEGFwd EPS grth FY+1Fwd EPS grth FY+23-mth MomNet Cash/ Debt (-)
Serica Energy AIM:SQZ£28m11p0.09--0.19.2%69%27%$22m
Sopheon AIM:SPE£6.6m91p0.147-0.219%52%43%$1m
Amiad Water SystemsAIM:AFS£41m180p0.23122.6%0.529%28%18%-$9m
Synectics AIM:SNX£27m165p0.31150.6%1.436%45%39%£1m
Lighthouse  AIM:LGT£18m14p0.32151.7%0.832%17%39%£8m
Interquest  AIM:ITQ£35m95p0.4483.2%0.717%12%21%-£6m
Augean AIM:AUG£51m50p0.4691.3%2.019%12%12%-£4m
SThreeLSE:STHR£432m338p0.46144.1%0.918%15%15%£6m
Dialight LSE:DIA£171m525p0.4725--57%43%17%-£4m
Marshall Motor Holdings AIM:MMH£141m182p0.5181.6%0.617%12%11%-£27m
Styles & Wood  AIM:STY£23m324p0.548-1.19.4%14%76%£0m
Stadium  AIM:SDM£41m111p0.54102.4%1.221%23%6.6%-£5m
Robert Walters LSE:RWA£249m335p0.55152.1%1.118%13%6.3%£18m
Brainjuicer  AIM:BJU£45m362p0.59141.2%1.39.9%13%23%£6m
Galasys AIM:GLS£21m28p0.62100.7%0.82.4%21%113%MYR31m
Avingtrans AIM:AVG£50m180p0.65-1.7%0.925%32%37%-£6m
Shoe Zone AIM:SHOE£104m208p0.67126.3%1.57.9%8.4%4.2%£14m

Source: S&P CapitalIQ