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
Name | TIDM | Total Return (22 Jun 2015 - 31 May 2016) |
---|---|---|
Highland Gold | HGM | 79% |
Lifeline Scientific | LSIC | 60% |
Dart Group | DTG | 58% |
Empresaria | EMR | 33% |
Martinco | MCO | 29% |
H&T Group | HAT | 20% |
Sirius Real Estate | SRE | 17% |
RTC | RTC | 8.8% |
Carclo | CAR | 4.8% |
Morgan Sindall | MGNS | 4.1% |
Hayward Tyler | HAYT | -1.5% |
City of London | CLIG | -1.6% |
Liontrust Asset Management | LIO | -6.5% |
Sthree | STHR | -8.7% |
Robert Walters | RWA | -13% |
Matchtech | MTEC | -19% |
NAHL | NAH | -20% |
Red24 | REDT | -26% |
Creston | CRE | -32% |
OPG Power Ventures | OPG | -35% |
Utilitywise | UTW | -41% |
Mothercare | MTC | -47% |
Gulf Marine Services | GMS | -55% |
Solid State | SOLI | -56% |
Globo | GBO | -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
Name | TIDM | Mkt Cap | Price | GV Ratio | Fwd NTM PE | DY | PEG | Fwd EPS grth FY+1 | Fwd EPS grth FY+2 | 3-mth Mom | Net Cash/ Debt (-) |
---|---|---|---|---|---|---|---|---|---|---|---|
Serica Energy | AIM:SQZ | £28m | 11p | 0.09 | - | - | 0.1 | 9.2% | 69% | 27% | $22m |
Sopheon | AIM:SPE | £6.6m | 91p | 0.14 | 7 | - | 0.2 | 19% | 52% | 43% | $1m |
Amiad Water Systems | AIM:AFS | £41m | 180p | 0.23 | 12 | 2.6% | 0.5 | 29% | 28% | 18% | -$9m |
Synectics | AIM:SNX | £27m | 165p | 0.31 | 15 | 0.6% | 1.4 | 36% | 45% | 39% | £1m |
Lighthouse | AIM:LGT | £18m | 14p | 0.32 | 15 | 1.7% | 0.8 | 32% | 17% | 39% | £8m |
Interquest | AIM:ITQ | £35m | 95p | 0.44 | 8 | 3.2% | 0.7 | 17% | 12% | 21% | -£6m |
Augean | AIM:AUG | £51m | 50p | 0.46 | 9 | 1.3% | 2.0 | 19% | 12% | 12% | -£4m |
SThree | LSE:STHR | £432m | 338p | 0.46 | 14 | 4.1% | 0.9 | 18% | 15% | 15% | £6m |
Dialight | LSE:DIA | £171m | 525p | 0.47 | 25 | - | - | 57% | 43% | 17% | -£4m |
Marshall Motor Holdings | AIM:MMH | £141m | 182p | 0.51 | 8 | 1.6% | 0.6 | 17% | 12% | 11% | -£27m |
Styles & Wood | AIM:STY | £23m | 324p | 0.54 | 8 | - | 1.1 | 9.4% | 14% | 76% | £0m |
Stadium | AIM:SDM | £41m | 111p | 0.54 | 10 | 2.4% | 1.2 | 21% | 23% | 6.6% | -£5m |
Robert Walters | LSE:RWA | £249m | 335p | 0.55 | 15 | 2.1% | 1.1 | 18% | 13% | 6.3% | £18m |
Brainjuicer | AIM:BJU | £45m | 362p | 0.59 | 14 | 1.2% | 1.3 | 9.9% | 13% | 23% | £6m |
Galasys | AIM:GLS | £21m | 28p | 0.62 | 10 | 0.7% | 0.8 | 2.4% | 21% | 113% | MYR31m |
Avingtrans | AIM:AVG | £50m | 180p | 0.65 | - | 1.7% | 0.9 | 25% | 32% | 37% | -£6m |
Shoe Zone | AIM:SHOE | £104m | 208p | 0.67 | 12 | 6.3% | 1.5 | 7.9% | 8.4% | 4.2% | £14m |
Source: S&P CapitalIQ