A score of cheap small-caps

One is the prospect of lower earnings, as investors factor higher energy and commodity prices into their future profit expectations. A second, as Chris Dillow wrote last week, is heightened risk aversion. Right now, any assumption about economic growth or energy prices feels inherently slippery, blurred by the wildly shifting possibilities of a fast-moving geopolitical calamity of unknowable length.

A knock-on effect of this ‘risk-off’ sentiment is that lots of companies suddenly look much cheaper than they did just a few weeks ago. By and large, analysts haven’t made major modifications to their forecasts over the past fortnight, though few will feel able to ignore the International Monetary Fund’s recent warning that “the ongoing war and associated sanctions will have a severe impact on the global economy”.

Against this backdrop, any discussion of what qualifies as a ‘cheap’ stock requires several pinches of salt. But uncertainty is a permanent feature of financial markets, and at any given moment investors can never truly know whether a stock is cheap for a reason.

It’s worth bearing all of this in mind as you digest the latest readings from this week’s stock screen, which uses the methods of famed contrarian investor David Dreman to try to identify cheap small-caps. As we have previously argued, these kinds of stocks can provide rich pickings for anyone prepared to tolerate severe swings in market sentiment. And it’s hard to think of any investor who has a choice on that front right now.

In the nine years we have been running the Cheap Small-caps screen, its selections have posted a total return of 186 per cent, or 138 per cent after factoring in a chunky 2 per cent annual dealing charge. That compares favourably, though perhaps unspectacularly, with the 86 per cent return from our composite FTSE Small Cap/Aim All-Share index, which we use as a proxy for smaller UK-listed companies.

Last year, pandemic disruption meant the screen found just one stock that ticked all of its boxes. Even waiving a requirement for year-on-year half-year sales growth left us with just two companies – home products specialist Up Global Sourcing (UPGS) and farm supplies outfit Carr’s (CARR) – in our basket of cheap small stocks. Fortunately, a strong performance from the agricultural business meant the picks handsomely outperformed their benchmarks (see table).

The evidence in favour of cheap or ‘value’ focused small-cap stocks is somewhat mixed, but broadly positive. In a 2004 study authored by the subject’s leading academics, Elroy Dimson, Paul Marsh and Mike Staunton, long-run returns from smaller companies across 14 European countries were found to have been lower than, or only modestly ahead, of those achieved by larger companies. Outside of the US – where value small-caps tended to do better than their larger peers – the study also found that a stock’s cheapness was a greater predictor of outperformance than its size.

In the years since, Dimson and Marsh have become well-known for their analysis of small company returns. But their observation that smaller stocks consistently outperform larger-caps in many markets is based on ordinary, market capitalisation-weighted indices, and so does not adjust for value.

Dreman for all seasons

Value is at the heart of Dreman’s take on stocks.

Like several other famed investors, including Benjamin Graham and Joel Greenblatt, he long ago concluded that markets can be deeply irrational, and that this often leads to disconnects between a company’s stock price and its overall value. To many, this position is considered contrarian, given the widespread prevalence of the efficient market hypothesis (which states that a security’s price is a fair and accurate reflection of all the publicly available information on it). Then again, Dreman’s belief in fundamentals and the value of forecasts as reliable proxies for a company’s quality and growth prospects shows his approach to stockpicking isn’t entirely unconventional.

Dreman wasn’t known as a big fan of small-cap stocks, but the screen can identify some interesting situations as a basis for further research – rather than an off-the-shelf portfolio. The screen’s full criteria are as follows:

Initially, the cheapest quarter of FTSE All Small and Aim All-Share stocks are identified based on either dividend yield (DY), forecast next-12-month price/earnings ratio (fwd NTM PE), price-to-cash-flow (P/CF), price-to-book-value (P/BV) or my predecessor Algy Hall's genuine value (GV) test. Shares that appear cheap on one or more of these valuation measures must also pass the following tests:

■ Underlying year-on-year EPS growth in the most recent half-year period.

■ Forecast EPS growth in each of the next two financial years (this test should be taken with a big pinch of salt at the moment, and passing it may have more to do with thin broker coverage than actual growth potential). 

■ 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. 

■ Dividend cover of 1.5 times or more, or above the three-year average.

■ For low PE ratio and low P/CF stocks, the dividend yield must be above the median average.

This year, the screen has had a lot more success in casting the net, having identified 20 small-caps that meet all of its criteria. Of these, eight also passed at least two of the ‘cheap’ tests, four passed three, and mineral sands excavator Kenmare Resources (KMR) performed unusually well by passing all but the low price-to-cash-flow test.

Details are in the table below, and in greater depth in the downloadable spreadsheet:

Source: FactSet