This gives me an opportunity to use my analytical skills to uncover hidden gems that other stock market miners have failed to discover. If the rationale behind my analysis proves on the mark, and I can identify a catalyst that will tempt other investors to buy into the apparent valuation anomaly I have spotted, then more often than not the shares will be re-rated in time.
A weight of stock market history supports having at least some exposure to small-caps in a sensibly structured investment portfolio. That's because the Numis Securities Smaller Companies index has produced an average annual return of 15.4 per cent between 1955 and 2015, easily outperforming the 11.7 per cent return on the FTSE All-Share in the same period. In more recent times, smaller companies have outperformed larger ones in 90 per cent of worldwide markets since the millennium. Interestingly, there is also evidence to support a balance sheet approach to investing within this space as in the long run companies trading on the lowest price-to-book value have outperformed growth stocks by quite some margin, albeit that value stocks do badly in economic downturns.
This particular analytical approach, which is one of the strategies I use to uncover anomalously priced value plays in the under-researched junior market, has served me well over the years. In fact, it's no coincidence that the top five performers in my 2016 Bargain Share portfolio - top level domain company Minds + Machines (MMX), litigation investment company Juridica Investments (JIL), oil explorer Bowleven (BLVN), investment company Volvere (VLE), and healthcare company Bioquell (BQE) - all retain robust and cash-rich balance sheets, the major benefit of which is to mitigate investment risk and focus investors' minds on the value on offer when a chunk of that cash pile is returned to shareholders, as has been the case with Minds + Machines, Juridica, Bioquell and Bowleven.
Although the 11 per cent return on the portfolio since launch in February is shy of that on the FTSE All-Share, I am positive of outperforming this benchmark in the coming months to maintain a record that has seen all but three of my portfolios beat the index in their first year on an annual basis in the past 17 years. A bias towards small-caps is the primary reason for this outperformance.
The other obvious benefit of my value-orientated approach to investing is that it screens out companies with rock-solid balance sheets and where the earnings potential of the business is underpriced in the current valuation. This is the case with all those five companies above. Another good example is Avingtrans (AVG:188p), a company that makes and supplies critical components and modules to the energy and medical sectors.
Even though the directors have a cracking track record of building up businesses and then selling them on successfully, the shares were effectively trading below cash on the balance sheet when I spotted a buying opportunity in the summer after the board completed a major disposal ('Engineering a profitable ride', 30 Jun 2016). A subsequent tender offer to buy back half the share capital at a near-20 per cent premium to my 170p buy in price has corrected some of the valuation anomaly. However, it's telling that only 35 per cent of the shares in issue were tendered, clearly suggesting that the majority of shareholders see significant further upside. And so do I, which is why my analysis points to a 230p target price as I highlighted in an update a few months ago ('High fives', 4 Oct 2016).
Lessons from small-cap investing
Of course, not all small-cap companies pass my litmus test, and over the course of a year I will pass over literally dozens of potential opportunities that fail to meet my stringent requirements. That's not to say that I don't highlight them, one of the many advantages of digital publishing and the internet age.
For instance, I had an in-depth results call in the summer with the chief executive and finance director of Blue Prism (PRSM:419p), a company that had just listed its shares on Aim and specialises in robot process automation (RPA), supplying a virtual workforce powered by software robots that are trained to automate routine back-office clerical tasks. I was impressed by the business model and reassured that the company appeared fully funded to achieve cash profit break-even. Analysts also noted at the time that sales momentum was proving way better than their previous expectations.
However, I wanted to see more evidence of contract momentum building, and hopefully exceeding forecasts, before getting involved. So I decided to keep the shares on my watchlist with a view to initiating coverage. From your correspondence it is clear that many of you decided that it was worth buying on the back of my article, a decision that has paid off as Blue Prism has been one of the best-performing IPOs this year: the shares have almost quadrupled in value since I outlined the investment case ('Robotic growth', 29 Jun 2016).
The case of Blue Prism highlights what is an important point: ultimately it's down to each individual investor to decide whether or not the prospective investment opportunities I highlight in this column meet their own risk profile, investment objectives, asset allocation, and offer adequate upside potential for the risk being taken. It goes without saying that no one should invest in any asset without carrying out their own due diligence as part of the overall decision-making process. It also highlights the financial rewards that are possible to be made in the small-cap space, and my own hunting ground, which is for the large part concentrated on Aim-traded and main board small-cap companies with a market capitalisation below £150m.
Of course, the potential for generating hefty financial rewards comes at a price and that is higher share price volatility, reduced liquidity and the potential for above-average losses on holdings that simply don't work out as planned. Moreover, you can also be stuck in positions for long periods before eventually realising gains. These factors are worth considering before you invest.
Balancing risk and rewards
I raise this point because at this time last year I highlighted an arbitrage trading opportunity in the Aim-traded shares of Plethora Solutions (PLE), a UK-based speciality pharmaceutical company dedicated to the development and marketing of products for the treatment and management of urological disorders ('The takeover game', 11 Nov 2015). The company had received a provisional bid approach from Hong Kong-listed Regent Pacific (Hong Kong Stock Code: 575), which was offering 15.7076 of its own shares for each Plethora share, representing a 170 per cent premium to Plethora's freely tradable price in the London market.
As a rule of thumb, when something looks too good to be true, it generally is. But in this case I felt that there was still enough upside to compensate for the risks involved, so suggested buying Plethora's shares in the London market, accepting the offer as and when a formal bid was announced, and then selling the new Regent Pacific paper in Hong Kong. By the spring, the deal had gone through and I recommended selling out in Hong Kong to bank a 122 per cent paper profit on the holding in only four months ('On the takeover trail', 14 Mar 2016). Of course there was always the risk that you would be unable to exit your holdings successfully if too many other investors decided to play the same game and take advantage of this arbitrage opportunity.
True, some readers did manage to double their money before Regent Pacific's share price deflated on the weight of selling pressure, but other holders were left patiently waiting for a more profitable exit. And that opportunity unveiled itself late last month as I highlighted in an online article ('Currency winners', 28 Nov 2016), and one in which I recommended banking at least some of the paper profit if you still owned shares in Regent Pacific.
One reader who did follow my advice has just emailed me to say: "After all the initial obstacles this time I managed to sell, realising a profit of 184 per cent, so the wait was well worth it and more than compensating the losses incurred on some of your other tips. This is what I expect from trading in small-caps and why, most years, I beat the index. I just suggest you emphasise from time to time the risks involved and the need to spread one's investments (small-caps represent 30 per cent in value of my portfolio, but 50 per cent in number of investments)."
I agree and that's why I have been making a concerted effort to write up a lengthy risk assessment on all the companies I initiated coverage on so that all readers, both those who have acted on my initial buy advice and those who have decided to purchase shares on a subsequent update, are fully aware of the potential pitfalls.
The reader's comments also highlight the swings-and-roundabouts nature of small-cap investing, and the fact that what matters most is that a portfolio generates 'alpha' over the long run, namely the excess return above that of the index it's benchmarked against. Most fund managers fail to achieve this, by the way, and would be far better just putting their clients' funds into an index tracker, not that it would justify their management fees if they did so. But that's not to say that a small-cap bias to your asset allocation doesn't work for many active private investors: the outperformance of my Bargain Shares portfolio over the years clearly proves it does.
Understanding small-cap liquidity risk
The issue of liquidity is always worth considering when it comes to trading in small-cap shares. This is why splitting orders into smaller bargain sizes can more often than not save the extra price market makers demand for executing a trade in one transaction, both on the bid and offer side. However, even if you have built up a decent position, you still need to be able to exit it when you want to take a profit, or cut your losses. There can be issues.
A good example was when I decided to call time at the start of this year on the Aim-traded shares of Tristel (TSTL:169p), a maker of infection prevention and hygiene products ('Investors spooked by bugbuster's sales slowdown', 24 Feb 2016). The shares had more than doubled on my advised buy in price of 60p ('Clean up on superbugs', 6 May 2014), and I had previously recommended running profits at 142p after my upgraded target price had been hit ('Running small-cap winners', 25 Nov 2015).
My change of stance followed the release of the company's half-year results, which showed the UK market stalling, a consequence of which is to increase its reliance on overseas sales to generate growth at a juncture when Tristel is also increasing investment in expanding into new territories, such as the US. This made me cautious, and with the shares rated on a cash-adjusted price/earnings (PE) ratio of almost 20, I believed that they were fully priced. I was not the only one thinking this way as analysts at Equity Development had trimmed back their target price from 140p to 125p, reflecting a more conservative sales trajectory, and brokerage FinnCap believed fair value was nearer 110p. The shares sold off sharply as small-cap investors bailed out to such an extent that they had fallen to 87p by early July.
There are several points worth making here. Firstly, never underestimate the difficulty of exiting a holding at a fair price when there is a paucity of buyers around and liquidity dries up. The most extreme case of this occurred in the final quarter of 2008 after global stock markets crashed during the banking crisis. Investor risk aversion was running so high that buyers were holding on to their cash even though the equity risk premium embedded in valuations had rocketed, equity market volatility was at record levels (a contrarian buy indicator), and valuations were completely out of sync with the fundamentals.
The situation was further exacerbated by the Icelandic banking crisis, which led to several of the country's overleveraged banks pulling out from their UK market making activities. But even in normal times, share prices will always have a tendency to overshoot both to the upside and downside, a reflection of the powers of greed and fear on investor behavioural patterns, a point worth considering given the generally lower liquidity levels when trading shares in UK smaller companies.
Secondly, and this is more specific to my own share recommendations, the spike in bargains that go through the London Stock Exchange post publication of my articles is usually well above the normal daily average, and more often than not many times higher. That's worth noting because if a trade is crowded then there is greater risk of paper profits being eroded when I change my share recommendation if the same investors who bought on the initial advice, or for that matter when I reiterate my buy advice, decide to exit all at the same time. This is why in my initiation of coverage I make a point of highlighting a company's shareholder base to ascertain the free float available in the market, and so levels of liquidity, and also give an indication of a tradeable bargain size.
Bearing this in mind, the trading volumes and prices at which bargains are transacted post publication of my investment columns are always worth noting. That's because they not only indicate the level at which new investors are prepared to buy in, but have a major bearing on the prices that stop-losses are triggered at if all doesn't go to plan. That said, I am just one market participant, albeit one that is followed by a large private shareholder readership base in the small-cap space, a responsibility I am all too aware of and one that I take very seriously when issuing share recommendations.
The final point is that having being sold down below fair value during the summer, Tristel's share price has since doubled to an all-time high following a better-than-expected trading update, and declaration of a special dividend. Although I missed an opportunity to advise buying back Tristel's shares during the post-Brexit equity market carnage, I don't regret banking the hefty profit in February. You can only act on the information available in the market at any point in time which, from my lens at least, suggested the shares were up with events. Moreover, the re-rating from the summer lows is more a reflection of earnings multiple expansion - the forward PE ratio has doubled to 26 since early July - than a material change in the earnings expectations on which I was basing my value judgment.
Impact of earnings contraction
However, I do regret not cutting losses earlier on recommendations that didn't work out and banking profits sooner on others. The case of Aim-traded telematics company Trakm8 (TRAK:118p) is a prime example and there are important lessons to be learnt here.
To recap, when I spotted that the company was in an earnings upgrade cycle in February last year, and one that had some way to run, the shares were priced at 92p ('Zoning in on a profitable price move', 16 Feb 2015). By the end of last year, the share price had quadrupled to 360p, helped in part by news of an extension to its relationship with the AA (AA. 275p) ('On a roll', 15 Dec 2015). New investors then came on board and backed a placing at 333p a share to fund an acquisition, the merits of which looked sound - which is why I subsequently upgraded my advice on the shares to a buy, at 300p, at the start of this year ('Tech watch, 13 Jan 2016).
That proved to be the high water mark, and the combination of a stiff currency headwind, orders being pushed back and weaker-than-expected sales growth led to a major earnings downgrade last month, which prompted me to exit the holding at 140p ('Currency winners', 28 Nov 2016). The subsequent selling pressure has sent the share price down further.
The key lesson here is that the downside risk post an earnings downgrade is far greater if the shares are highly rated to start with, as investors will undoubtedly attribute a lower multiple to a company's earnings in their valuation given the higher perceived risk to future earnings. In the case of Trakm8, the forward PE ratio had risen from 11 when I commenced coverage to 20 by the end of last year, so was a major driver in the share price quadrupling. But with future earnings expectations taking a hit, the multiple being attributed to the shares has fallen to 11 times downgraded prospective earnings based on analysts' new EPS estimates of 9.9p, a hefty 42 per cent below their previous forecasts of around 17p only three months ago. In effect, the earnings multiple contraction has accounted for half the share price fall this year, with the balance being the lower EPS on which the valuation is based.
Riding off the coat-tails of earnings expansion
That's not to say that a strategy of targeting companies benefiting from earnings upgrades, and where multiple expansion is a factor in share price outperformance, hasn't proved to be a profitable investment strategy. It clearly has as a raft of small-cap companies on my watchlist have benefited from these twin share price drivers over the course of this year, including: Trifast (TRI:190p), a distributor of fasteners; AB Dynamics (ABDP:505p), a specialist in advanced testing systems and measurement products to the car industry; and Burford Capital (BUR:482p), a provider of investment capital and professional services for litigation cases.
These holdings are showing total returns of 271 per cent, 195 per cent and 235 per cent, respectively, since I initiated coverage and are all worth holding on to if you followed my earlier advice as the earnings upgrade cycles that have been driving share price outperformance look to have further to run.
It's interesting to note that all three companies have been benefiting from a strong currency tailwind, something worth keeping a close eye on given the positive impact this has had on the earnings of hundreds of UK-listed companies.
Exploiting currency plays
Indeed, targeting companies operating in sectors with a positive trading environment, and enjoying a currency tailwind on overseas earnings, has also been a profitable strategy and highly supportive of the share prices of several of my small-cap selections, including: small-cap property fund manager First Property Group (FPO:47p); Avation (AVAP:195p), an aircraft leasing company; Alpha Real Trust (ARTL:102p), an investment company in high-yielding property and asset-backed debt; Somero Enterprises (SOM:222p), a Florida-headquartered company specialising in laser-guided concrete levelling equipment for commercial floors; and Amino Technologies (AMO:176p), the Cambridge-based provider of digital entertainment solutions for IPTV internet TV. I maintain buy recommendations on the first three companies and am comfortable running profits on Somero and Amino.
The point here is that the sterling:dollar exchange rate averaged £1:US$1.528 in 2015, has averaged £1:US$1.353 this year, and the current cross rate of £1:US$1.27 is 16 per cent lower than 12 months ago. The devaluation in the sterling:euro rate is of a similar magnitude. In many cases, the full impact of the currency slide on the future earnings of UK companies with overseas sales exposure has yet to be seen, a good enough reason to target companies where currency-driven earnings momentum is still being underpriced in the valuation.
Of course, the Supreme Court ruling to decide whether the UK parliament is required to vote before the government can trigger Article 50 to start the formal process of leaving the EU has potential to create volatility in currency markets, as will the nature of the UK's exit from the single market. However, I see this as an opportunity to pick undervalued special situations rather than try to second-guess the final outcome of the Brexit discussions with our European cousins in Brussels. It could be a tortuous affair.
M&A plays still pay
Another ongoing theme is bid activity focused on the small-cap segment of the market. In fact, no fewer than 13 companies on my small-cap buy list have made a stock market exit since the start of last year, the average premium on which has been well over 50 per cent above my initial entry point.
For instance, The Wireless Group, an operator of regional radio stations in the UK and Ireland and of the commercial sports station talkSPORT, has been taken over by media giant News Corp. The recommended cash bid valued the equity at 315p a share, or £220m, representing a thumping 70 per cent plus bid premium to my 185p buy-in price ('On the right wavelength', 26 Oct 2015). For good measure, I highlighted the potential for the company to outperform during last summer's Euro 2016 football championship a matter of weeks before the bid was announced ('Wireless Group set to score', 23 Jun 2016). It's clear from your correspondence that many of you bought in at the time.
It was not an isolated example as Aim-traded shares in Constellation Healthcare Technologies (CTH:218p) soared at the end of last month after the company's founder teamed up with a private equity firm to launch a bid pitched 50 per cent higher than my buy-in price, albeit I have serious reservations about the terms of the offer ('Aim delistings', 28 Nov 2016).
The fact that so many small-cap companies are being taken over is noteworthy, a reflection of the fact that cash-generative and modestly geared businesses with solid balance sheets remain attractive to larger rivals and private equity firms, which are able to readily access cheap credit and gear up the target's balance sheet. I don't expect this activity to end any time soon, a good enough reason to continue to search for companies exhibiting solid finances, and where the differential between earnings yields - the reciprocal of the PE ratio - and the cost of corporate debt is such that there is an incentive for an acquirer to offer a bid premium.
A consequence of the ongoing bid activity in my small-cap space, and the fact that I now have run profit recommendations on literally dozens of my share recommendations, is that I am always on the search for new companies to consider commencing coverage on. Aim listings have proved a fertile hunting ground - tissue maker Accrol (ACRL:128p) and student accommodation construction company Watkin Jones (WJG:118p) are two of the small-cap winners in the new issues market I have managed to screen out from this year's offering. Expect more of the same in the coming year, and one in which I believe the ability of stockpickers to generate above-average returns is likely to come into the fore, a challenge I am relishing already.
MORE FROM SIMON THOMPSON...
Please note that I have analysed the investment case of more than 100 companies since the start of September, all of which are available on my homepage.
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