For many investors, cheap shares present a guttural lure and there is plenty of academic work that suggests focusing on buying shares trading on low valuations can provide solid foundations for market outperformance. However, it is often hard to stick with such a strategy due to the danagers of being allured by value traps rather than real value opportunities. Value traps have arguably weighed on the performance of my Cheap Small Cap screen over the past year.
Over the period the screen delivered a total return of 10.3 per cent compared with 29.0 per cent from a blend of the FTSE Small Cap and Aim All-Share, which are the indices on which the screen is conducted. While the screen did once again highlight some shares that produced stellar gains over the period, it also picked some real stinkers (see table).
2016 PERFORMANCE
| Name | TIDM | Total Return (30 Mar 2016 to 10 Apr 2017) |
|---|---|---|
| Games Workshop | GAW | 121% |
| ULS Technology | ULS | 80% |
| Sirius Real Estate | SRE | 64% |
| Air Partners | AIR | 45% |
| Numis | NUM | 29% |
| Solid State | SOLI | 21% |
| Communisis | CMS | 20% |
| The Property Franchise Group | TPFG | 17% |
| NewRiver REIT | NRR | 11% |
| Alumasc | ALU | 1.9% |
| Manx Telecoms | MANX | -1.5% |
| Norcros | NXR | -5.8% |
| Shoe Zone | SHOE | -7.5% |
| Digital Globe Services* | DGS | -22% |
| Plus500 | PLUS | -23% |
| Novae | NVA | -25% |
| Foxtons | FOXT | -34% |
| Braemar Shipping | BMS | -35% |
| Interquest | ITQ | -60% |
| FTSE Aim All-Share | - | 34% |
| FTSE Small Cap | - | 24% |
| FTSE Small Cap/Aim | - | 29% |
| Cheap Small Caps | - | 10% |
*Taken over
Source: Thomson Datastream
This is undoubtedly one of the higher-risk screens I monitor in this column and it has spent as many of the four years I’ve run it underperforming the market as it has outperforming it. Still, overall the screen has done better than an equal split between the FTSE Small Cap and Aim All-Share since inception producing a cumulative total return of 51.3 per cent compared with 49.5. That said, it has underperformed the FTSE Small Cap on its own, which has returned 58.8 per cent. Also, given this screen focuses on smaller companies, the issue of dealing costs is also important. If I factor in an annual 2 per cent charge for this, the cumulative return from the screen falls to 39.5 per cent, below the FTSE Small Cap/Aim blend.
Cheap small caps
The screening criteria is based on the approach of contrarian king David Dreman. Mr Dreman was actually not an advocate of using his methods for small cap investing and I also run a screen for this column using his approach to find promising larger companies. However, the balance between low valuation and attractive fundamentals should have some relevance for small caps even if it means investors have to be alert to the prospects of higher risks.
The screen’s kick off point is to identify the cheapest quarter of the near 1,200 stocks screened based on either dividend yield (DY), forecast next-twelve-month price-to-earnings ratio (fwd NTM PE), price-to-cash-flow (PCF), price-to-book-value (PBV) or the genuine-value ratio (GV). Last week’s column provides a fulsome explanation of the GV ratio but the basic premise to compare a company’s earnings-based valuation with its potential for earnings growth and dividend payment. Shares that appear cheap on one or more of these valuation measures must also pass the following tests (the tests vary slightly depending on what metric stocks appear cheap against):
■ Underlying year-on-year EPS growth in the most recent half-year period. ■ Forecast EPS growth in each of the next two financial years. For shares qualifying based on a low GV ratio, I have eliminated any companies with an average forecast growth rate over the next two years of over 50 per cent, as such strong growth could prove unsustainable. ■ A current ratio (net current assets/net current liabilities) of more than one, which suggests a company is in a good position to pay its upcoming bills. ■ Gearing (net debt/net asset value) must be less than 75 per cent, or net debt must be less than two times cash profits (Ebitda). ■ The company must pass at least one of Mr Dreman's two quality tests: having operating margins better than 8 per cent or a return on equity of more than 10 per cent. Companies qualifying based on our GV ratio must pass both tests. ■ Dividend cover of 1.5 times or more, or above the three-year average. ■ For low PE ratio and low P/CF stocks I've also applied Mr Dreman's test that dividend yield should be above the median average, which reflects the importance he attaches to yield in achieving returns. |
A total of 17 stocks met the screen’s criteria and these are presented in the table below. I’ve also taken a closer look at three of the shares to give a flavour of the screen’s results and I’ve selected shares that look particularly cheap based on DY, fwd PE and PCF.
17 CHEAP SMALL CAPS
| Name | TIDM | Mkt Cap | Price | GV | Fwd NTM PE | DY | PEG | PBV | PCF | Div Cov | Fwd EPS grth FY+1 | Fwd EPS grth FY+2 | 3-mth Mom | Net Cash/Debt (-) | Cheap |
|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|---|
| Gateley | AIM: GTLY | £175m | 164p | 1.09 | 16 | 4.6% | 1.79 | 13.9 | 13.0 | 1.63 | 14.1% | 7.2% | 26.3% | -£7m | DY |
| Morgan Sindall | LSE: MGNS | £443m | 1,007p | 0.30 | 11 | 3.5% | 0.95 | 1.60 | 2.5 | 2.79 | 11.9% | 12.5% | 25.9% | £208m | PCF |
| Property Franchise Group | AIM: TPFG | £39m | 156p | 0.72 | 10 | 4.2% | 1.01 | 3.24 | 16.6 | 2.13 | 8.2% | 14.8% | 20.2% | -£1m | PE |
| Low & Bonar | LSE: LWB | £240m | 73p | 0.37 | 10 | 4.1% | 0.55 | 1.23 | 13.2 | 1.51 | 40.4% | 7.8% | 11.4% | -£111m | PE |
| Alumasc | LSE: ALU | £62m | 174p | 0.70 | 9 | 3.7% | 1.57 | 3.72 | 16.5 | 2.89 | 8.0% | 7.0% | 8.6% | £5m | PE |
| Air Partner | LSE: AIR | £53m | 104p | 0.32 | 14 | 4.7% | 1.29 | 3.66 | 4.4 | 1.12 | 27.3% | 12.0% | 7.4% | £19m | DY, PCF, GV |
| Jarvis Securities | AIM: JIM | £42m | 378p | - | 14 | 4.6% | 3.63 | 8.67 | - | 1.51 | 5.8% | 2.0% | 3.6% | £5m | DY |
| Moss Bros | LSE: MOSB | £98m | 98p | 0.66 | 19 | 6.0% | 1.68 | 2.62 | 6.2 | 0.97 | 15.8% | 5.0% | 3.6% | £20m | DY, PCF |
| Jersey Electricity | LSE: JEL | £131m | 428p | 1.63 | 12 | 3.9% | 4.05 | 0.80 | 5.2 | 2.84 | 3.0% | 2.5% | 1.9% | -£29m | PCF |
| Billington | AIM: BILN | £29m | 240p | 0.55 | 9 | 4.2% | 1.22 | 1.54 | 5.3 | 4.03 | 3.1% | 12.0% | 1.9% | £4m | PE |
| XLMedia | AIM: XLM | £215m | 108p | 0.59 | 11 | 5.7% | 1.50 | 2.58 | 8.0 | 1.94 | 3.6% | 10.8% | 0.9% | $35m | DY, PE, GV |
| Sthree | LSE: STHR | £404m | 315p | 0.68 | 15 | 4.5% | 1.59 | 5.27 | 11.9 | 1.52 | 4.9% | 13.6% | -2.0% | £10m | DY |
| MacFarlane | LSE: MACF | £82m | 61p | 0.57 | 10 | 3.2% | 0.75 | 2.10 | 25.0 | 2.57 | 29.3% | 4.3% | -2.3% | -£16m | PE |
| Shoe Zone* | AIM: SHOE | £88m | 175p | 0.99 | 10 | 10.3% | 7.27 | 2.94 | 7.4 | 1.72 | 1.2% | 1.7% | -4.1% | £15m | DY, PE, PCF |
| Character Group | AIM: CCT | £102m | 483p | 0.79 | 10 | 3.3% | 1.66 | 4.51 | 12.4 | 3.87 | 4.6% | 7.1% | -6.1% | £7m | PE |
| United Carpets | AIM: UCG | £8m | 10p | 0.50 | 6 | 4.0% | 1.53 | 1.77 | 6.0 | 4.16 | 2.0% | 6.4% | -8.2% | £2m | PE, PCF |
| ScS | LSE: SCS | £64m | 161p | 0.20 | - | 9.0% | 2.13 | 2.72 | 4.0 | 1.61 | 1.1% | 5.9% | -10.9% | £37m | DY, PCF |
*Includes special divi
source: S&P CapitalIQ
HIGH YIELD: Shoe Zone
A double-digit dividend yield is normally a sign of a company in deep trouble, but in the case of Shoe Zone (SHOE), a retailer of bargain footwear, the income attractions have some genuine promise. For one thing, almost half of the bumper yield reported in our table represents last year’s special payout of 8p, which sat atop of a 10.3p basic payout. But while the “special” nature of the 8p top-up payment means investors should not take a repeat performance for granted, there was also a 6p special payment in 2015 and many believe the company’s strong cash flows could underpin a further shareholder treat this year.
The dividend attractions of ShoeZone should also be seen in the context of the company’s limited growth ambitions. As long as this is the case, shareholders should expect much of their return from the shares to come from income. Indeed, last year ShoeZone’s revenues fell by 4 per cent last year, which was largely due to the closure of loss-making stores.
While the company’s pragmatic approach to its 500-plus store estate may mean top-line declines, it also holds noteworthy attractions. ShoeZone rents its shops and the length of its leases are very short at just over two and a half years on average. At a time when high-street landlords are struggling to find and keep tenants, these short leases put the company in a strong position to barter down rents when leases are up. Management’s pragmatic approach extends to store refurbishments, too, which helps keep capital expenditure down and cash conversion up. Indeed, impressive cash generation meant net cash rose last year despite the large dividend payouts. The net cash itself is counter-balanced to some extent by a £13m pension deficit and the group’s lease liabilities, which Sharepad estimates a value of £157m for.
While ShoeZone definitely should not be considered a growth stock at the moment, it is looking at opportunities to expand. It has trialled three “big box” out-of-town stores with good results and six more could be opened this year. The company has also set up a small online operation which has the potential to provide it with growth opportunities both in the UK and overseas. Current trading conditions look tough, though, with the group facing rising costs and weaker consumer demand, which are likely to offset its own initiatives to improve its gross margins.
Last IC View: Buy, 180p, 19 Jan 2017
LOW FWD PE: Alumasc
Last year Alumasc (ALU) completed its disposals of non-core divisions with the sale of an engineering products business. However, its first year as a company fully focused on niche building products ranging from green roofs to solar shading, has been somewhat marred by the impact of Brexit. Indeed, while demand has shown little sign of slowing, raw material cost increases caused by sterling’s plunge contributed to a marked drop in first half operating margins from 9.5 per cent to 8.2 per cent. That meant the impressive 17 per cent increase in first-half turnover resulted in only 2 per cent pre-tax profit growth.
There are grounds to be more optimistic about the second half when the company expects to pass on cost increases with price rises. The group should also see the benefits an increase in first half overheads to support growth as well as a number of large contract completions. The company has also benefited from increased overseas work helped by sterling’s decline and the order book hit a new record after a £5m solar-shading contract win in Feburary. The group’s solar-shading business has been trading particularly strongly recently, although, all four of its division are growing sales.
While the company has net cash, it also has a sizeable pension deficit which is proving a noteworthy drain on its cash flows. A recent triennial review put the size of the pension shortfall at £33m which means the company is expected to continue to have to hand over £3.2m a year for the next decade. Nevertheless, the company saw fit to increase its dividend at the half year stage and if some of the damage to profitability done in the first half is reversed during the second half, there is reason to think the shares could re-rate off the current lowly earnings multiple.
Last IC View: Buy, 171p, 1 Feb 2017
LOW PCF: ScS
From the perspective of cash flows, upholstered furniture and flooring retailer ScS (SCS) is an interesting beast. The company gets paid by its customers (through a deposit at the time of an order and the rest around the time of delivery) before it has to pay its suppliers (at the end of the month following delivery). This means ScS operates with negative working capital, which has the affect of providing the group with extra cash as it grows. Attractive as this is during good times, it is worth remembering that this dynamic can work in reverse too and the low PCF ratio identified by this screen should be seen in this light.
The low valuation commanded by ScS’s shares reflects the market’s nervousness about trading prospects this year, especially the company reported challenging conditions in February. Big ticket items such as sofas could prove particularly vulnerable to any downturn in consumer sentiment, which many analysts predict will happen as the economic consequences of Brexit feed through the system.
What’s more, ScS’s balance sheet is arguably not as strong as it first appears. Indeed, the net cash shown in the accompanying table is to an extent necessary to balance out the fact that its current assets (represented by first-half receivables and inventories) only cover about half its £65m of current liabilities. More significantly, investors need to consider the large debt-like rental commitments ScS has against its 100-store estate. Sharepad estimates the value of this liability (something that companies will need to report on their balance sheets from the start of 2019) at £187m.
Concerns about slowing market conditions are likely to be elevated in investors’ minds at the moment by the fact that ScS has yet to go through its key Easter and May bank holiday trading periods, and comparisons with last year look tough. Still, encouragement can be taken from the group’s focus on growth opportunities, which include its 28 concessions in House of Fraser stores, growing online sales, and its flooring business.
Last IC View: na
