A quartet of high-quality small caps

These qualities aren’t out of reach for the humble small cap, but nor are they easy to build in short order. And because ‘small’ is usually synonymous with ‘room for growth’, small caps often attract racy valuations. When interest rates rise, recession looms and markets retrench, discounted cash flow estimates get trimmed, cutting down the most highly valued poppies first.

All of which is to say it’s been a tough old slog of late for investors in smaller companies. That much is clear from the performance of our High-Quality Small Cap screen, which posted a 17.7 per cent negative total return in the year to 16 August. While just ahead of its benchmark – a fifty-fifty mash-up of the freefalling Aim All-Share index and the slightly-more-resilient FTSE All-Small – it’s nothing to write home about.

2021 Performance

Source: Refinitiv

But write about it we must, if only in the service of dispassionate and systematic stock-picking strategies.

And depending on how you look at it, the strategy has done OK since we started following it a decade ago. Although our annual reshuffle of high-quality small companies has lagged the rather overlooked and quality-focused FTSE All-Small – an index whose total return is just under double that of the larger FTSE All-Share over the same period – it has handily outperformed the junior market, generating a return of around 10 per cent a year. That equates to a 10-year total return of 176 per cent, compared with 109 per cent from the benchmark.

One of the downsides of small-cap investing is the trading costs, which are exacerbated in a portfolio that moves in and out of positions every year. The big reason for this is liquidity, and the difference between the market price at which shares can be bought and sold (the so-called bid-offer spread), which tends to be wider the smaller the concern.

To illustrate this expense, the addition of a 2 per cent notional annual dealing charge to the screen pares back its decade-long total return to 126 per cent and barely above the index hybrid. While factoring in frictional trading costs helps show the real-world impact of trading on a portfolio, like most of the screens run in this column, the intention is to produce ideas for further research rather than an off-the-shelf fund.

The high-quality screen works by looking for stocks with signs of operational excellence across the balance sheet, cash flow and income statements. These include a track record of solid and growing returns on equity and operating margins, as well as manageable borrowings and good cash management.

Its full screening criteria are as follows:

• PE ratio above bottom fifth and below top fifth of all stocks screened.
• A genuine value (GV) ratio below the top quarter of stocks screened. GV ratio = (enterprise value/operating profit)/(forecast EPS growth + dividend yield).

• Earnings growth forecast in each of the next two financial years.
• Interest cover of five times or more.
• Positive free cash flow.
• Market capitalisation of at least £20mn, but below £1bn.
• Operating profit and return on equity growth over the past three years.
• An above-average return on equity in each of the past three years.
• An above-average operating margin in each of the past three years.

In a bid to maximise the number of results, I have kept last year’s slightly weakened criteria for the final two tests, which lowered the bar on returns on equity and operating margins from the top third to simply above average for each of the last three years. Still, I am persuaded by the fundamentals of the four stocks which passed all tests, details of which are provided below alongside a write-up of the one FTSE Small constituent which made the cut.

All four posted top-tercile returns on equity in each of the last two years, and top-tercile margins in all but one case. Support services firm Sureserve (SUR), which also appears in this week’s ideas section, is the only stock that would have missed the old test on margins. But it has shown the best relative improvement of the cohort in both margins and return on equity.

Norcros

When he handed over this screen at the start of 2022, its creator Algy Hall warned that years of steadily higher re-ratings in quality stocks meant it was largely fruitless to add in a valuation factor. Trimming the wildly cheap and the wildly expensive was the best you could do; otherwise, little existed in the way of price discovery.

I’m not sure whether the correction in small caps is to blame, but the screen now seems to have an easier time of picking stocks that look cheap. Nowhere is this more apparent than interior products group Norcros (NXR), which also scored highly in last week’s Contrarian Value screen thanks to its decent margins, forecast earnings growth, and a trailing enterprise value-to-sales ratio of 0.5.

Cheap, quality and throwing off cash. What, the prospective investor should immediately wonder, is the catch?

The best place to start is with the sector in which Norcros operates. Headquartered in Wilmslow, Cheshire, the business sells a wide range of higher-end bathroom and kitchen products, including showers, taps, tiles, and wall-mounted cupboards, through a portfolio of nine businesses. The newest of these, Edinburgh-based waterproof bathroom wall panel specialist Grant Westfield, was acquired in May for up to £92mn. Norcros also owns a South African arm which runs four plumbing and tile subsidiaries from a shared manufacturing and administrative site near Johannesburg. In the year to March, it accounted for 35 per cent of group revenues.

These products, made for both residential and commercial settings, are marketed to a wide array of clients, including architects, designers, developers, retailers and wholesalers, meaning sales aren’t overly dependent on the whims and spending habits of ordinary DIY enthusiasts.

This is a positive. Since everyone emerged from endless cycles of lockdown, blinking at the light, discretionary spending on home improvements has softened. Earlier this month, analysts at Jefferies noted that falling year-on-year web visits to multi-channel DIY firms Toolstation and Screwfix – subsidiaries of Travis Perkins (TPK) and Kingfisher (KGF), respectively – had continued into the summer. Add rock-bottom consumer confidence, and 2020-21’s surge in the repair, maintenance and improvement (RMI) market now feels all-but forgotten.

Norcros’ broad customer base and geographic diversification should shield it from some of this pain. It also helps explain why both the board and chief executive Nick Kelsall reiterated their confidence in hitting full-year expectations of “further progress and share gains” at last month’s annual meeting. Near-term momentum is all in the service of an ambition to grow revenue to £600m by 2025 – up from £396mn in FY2022 – while maintaining the average pre-tax return on underlying capital employed at more than 15 per cent.

The integration of Grant Westfield is unlikely to help with more than a third of that top-line growth target, given its sales were £42.2mn in the 2021 calendar year. But the acquired business does possess a few excellent characteristics – including an average 100 per cent cash conversion rate since 2019, low capital intensity, and a trailing adjusted cash profit margin which at 24 per cent is more than double Norcros’ figure – that should help the group-wide capital return (and recycling) targets.

The takeover, funded through a mix of cash reserves, debt and £19mn in fresh equity, means Norcros’ enterprise value is now closer to £240mn, or 0.6 times trailing sales. On less than six times forward earnings, the shares are also much cheaper than the eight times cash profits multiple paid for Grant Westfield.

Even if like-for-like sales growth stalls this year, Norcros occupies a nice part of its market. While it must handle often unpredictable raw materials and energy prices – and perhaps most critically, shipping costs from China, where many of its products are made – its role as domestic designer/supplier both avoids the high overheads that bug retailers and gives a clear overview of the value chain.

The business’s capacity to reinvent product lines is also encouraging. In the year to March, 29 per cent of revenue came from products launched in the previous three years, suggesting management knows how to move with demand. Snags and headwinds exist, but there is a mismatch between current evidence and the market’s apparent view that Norcros' shares are cheap for a reason.