It’s important to distinguish between valuation anomalies and value traps. Some companies are lowly rated for a reason. For instance, if quality of management, pricing power, profit margins, cash flow generation, return on capital and economic value added – the rate of return (ROR) over a company's cost of capital – are below par, then don’t expect investors to pay a full valuation for a slice of the action.
However, as I pointed out in my 2021 Bargain Shares portfolio, investors regularly overlook decent under-researched small-cap companies to such a degree that they can trade on unwarranted ratings discounts to larger peers. Of course, you need a catalyst to narrow the valuation discrepancy, so it pays to identify when one is likely to materialise. Nonetheless, when investors cotton on to the anomaly, the discounts can narrow markedly.
That’s exactly what I expect to happen with ThinkSmart (TSL), which is trading well below the value of its assets after accounting for all liabilities. In the case of currency manager Record (REC), prospects for a ramp-up in earnings is simply not reflected in a cash-adjusted forward price/earnings (PE) ratio of 9, nor a prospective dividend yield of 9 per cent. It’s a similar story at Hargreaves Services (HSP:296p), a diversified industrial services group, while building materials group SigmaRoc (SRC:70p) is in a strong upgrade cycle that continues to gain traction.