Three small caps on steroids

So it’s with a sense of relief that we can report a rare bout of stunning outperformance this week, courtesy of our Small Caps on Steroids screen. The four stocks selected by our high-risk, high-leverage approach in September 2021 not only beat the screen’s benchmark but trounced it.

Despite a big reverse from one of its members – construction and infrastructure services group Kier (KIE) – the selections produced a 20.4 per cent total return, some 42.8 percentage points above the average return from the two UK indices it aims to better.

That swing brings the cumulative total return over the four years the screen has been running to 45.6 per cent, versus 1 per cent from a 50-50 split of the FTSE Small Cap and Aim All-Share indices. While the screens that appear in these pages are meant as a source of ideas rather than off-the-shelf portfolios, by adding a chunky 2.5 per cent annual charge to represent the high cost of dealing in unloved small caps, the cumulative total return drops to 31.8 per cent.

That equates to an annual compound growth rate of 7.1 per cent, which given everything that has passed since the final quarter of 2018 feels like a respectable record.

In keeping with the screen’s history, the 2021 picks were nothing if not volatile, as you would expect of a group whose best performer, Nigeria-focused oil and gas producer-processor Savannah Energy (SAVE), was untradeable for the first three months of the period as it completed a major transaction.

Miner Petra Diamonds (PDL), the screen’s second-best performer, managed to return 42 per cent despite seeing its shares drop by almost a third shortly after its selection. Though a share consolidation, weak pricing forecasts and a showdown with the Tanzanian government initially sent investors packing, sentiment improved with the successful sale of several exceptional stones, firmer bulk prices and a rapprochement with the east African state.

Then again, whipsawing market sentiment is all but guaranteed by the screen, which seeks out stocks with low valuations and higher-than-average levels of debt.

Its genesis was sparked by a 2015 paper by Brian Chingono and Daniel Rasmussen of Verdad Capital, titled 'Leveraged Small Value Equities'. While the combination of big borrowings and cheap market valuations is often associated with companies forced to prioritise paying lenders over creating value for shareholders, the pair offered an alternative viewpoint of indebted, so-called value traps.

By focusing on US-listed small caps and testing their hypothesis against six decades of market data, they developed a ranking system that “prioritizes smaller, cheaper and more leveraged stocks that are already paying down debt and exhibit improving asset turnover”. Key to this system is evidence of de-leveraging, as a kind of proxy signal for the potentially rapid transfer of value to shareholders.

This dynamic, Chingono and Rasmussen found, was especially powerful because by reducing debt and the amount of operating cash flow that needs to be funnelled to interest payments, the balance sheets of de-leveraging companies become less risky. This in turn can lead to investors applying a higher value to the company’s shares, and a potential multiplier effect that explains the authors’ reference to “small-caps on steroids” in the report.

Higher rates, more juice?

In back-testing their novel investment strategy Chingono and Rasmussen found that leveraged value stocks generated an average risk-adjusted return of 13.1 per cent between 1965 and 2013, after controlling for risk, size, valuation, momentum and liquidity. That suggests the methodology held some weight throughout numerous business and economic cycles.

But the paper found that leveraged stocks didn’t escape the painful shocks of the early 1970s. Conversely, steroid stocks’ greatest rolling average returns came in the years following the 2008 financial crisis, when a drop in US interest rates to almost zero and massive monetary stimulus helped boost the share prices of firms that until recently had been deemed on the brink of collapse.

What can we expect from highly leveraged small caps now, as rapidly rising interest rates vie to keep pace with rocketing inflation?

The short answer is that it largely depends on the sector. Companies with a degree of pricing power or which – like screen returnee Savannah Energy – may benefit from higher output and commodities prices.

In a sense, the companies the screen hunts for have something in common with last week’s fiscal gamble from the UK government: load up on debt, and hope that explosive output growth will pave the way for a faster pace of de-leveraging than would otherwise have been possible.

The key distinction is that while both the UK’s currency and its major stock indices look cheap compared with international peers, borrowing has jumped dramatically in the last year, rather than fallen. Few companies right now are tapping debt markets.  

In other words, if the UK economy were a small cap, it wouldn’t pass our screen, the full criteria for which are:

• Among the cheapest third of stocks based on the enterprise Value (EV) to earnings before interest, tax, depreciation and amortisation (Ebitda) multiple.

EV is calculated using the basic method of adding net debt (including preference shares and lease liabilities but not pension deficits) to market capitalisation.

• A market capitalisation of less than £750mn, but more than £25mn.
• Improving asset turnover (sales to total assets) over the past 12 months.

• Falling net debt over the past 12 months.

• Net debt to EV that is the higher of either the median average of all companies with net debt or 33.3 per cent.

This year, just two companies – last year’s best and worst performers, Savannah Energy and Kier, respectively – passed all five tests. So in the interests of diversification, I have lowered the bar for the final test to allow companies which the median average net debt to EV ratio of 19 per cent. That admits just one extra stock, specialty baker Finsbury Food (FIF), whose ongoing international expansion looks like a canny move at a time of slowing domestic growth.

Aside from the thin pickings, one other aspect of this year’s results jumped out. For reasons unknown, the screen managed to pick up Marshall Motor Holdings, despite it delisting earlier this year after being acquired by Constellation Automotive. Fellow car dealership and 2021 screen pick Pendragon (PDG), which this week received its own £400mn takeover offer, also narrowly missed out on passing all five tests.

This might be a theme. With UK assets priced as cheaply as they are, it is likely that indebted-but-growing businesses with assets or operations that can be scaled internationally will continue to attract long-term investors with deep enough pockets to absorb or write off borrowings.

Details of the three companies which made this year’s cut can be found in the table at the end of the article with extra fundamentals in the downloadable excel version.