Six high-yielding small caps

Although their recent performances have been lacklustre, there’s a solid long-term reason for our general interest in smaller listed companies. According to data produced by Dartmouth College finance professor Kenneth French, small-cap stocks’ annualised returns have beaten their larger counterparts by a two percentage point margin over the past half-century.

That pattern holds in both the US and other developed international markets, and means that despite their higher average volatility, small caps are a proven and valuable source of outperformance, a factor that stockpickers would therefore do well to consider – not least following their recent struggles (more on this momentarily).

In fact, one could argue that retail investors should have a small-cap bias, regardless.

While smaller companies can lack the economic moats, balance sheet resilience and economies of scale of larger market-leading firms, they are also frequently under-researched, under-indexed and under the radar of larger asset managers who only consider investments above a certain threshold. DIY stockpickers, while sometimes at an informational disadvantage, don’t tend to have this issue.

Another reason why the size-based factor is a good subject for this stock screen column is that small caps rarely become large caps (or vice versa) in the course of a year. Given we tend to review our screens on an annual basis, this acts as a useful control. By contrast, other style factors such as value can quickly swing in and out of fashion – see for example the market’s abandonment of racy growth stocks since the end of 2021.

By focusing on stocks of a certain size, this also allows us to isolate secondary factors. This week’s entry, the High Yield Small-Cap screen, is at its core interested in cheaper stocks. But it also aims to balance this against evidence of growth and income generation, with a couple of classic quality tests thrown in for good measure.

These weren’t enough to prevent a poor run for our 2021 selections, which posted a 23 per cent loss on a total return basis. While ahead of the Aim All-Share index, this was a considerable underperformance against the FTSE Small Cap index (see table), and far below the screen’s long-term trend. The screen has racked up a respectable 237 per cent total return in the decade we have been running it. That’s a compound annual growth rate of 13.4 per cent, and well ahead of the 84 per cent long-run average return from the two smaller indices.

2021 selections

The cumulative performance assumes annual reshuffles of the portfolio to the new screen selection at close on the day of its online publication. While the screens on this page are not designed as off-the-shelf portfolios, by adding a chunky annual charge of 2.5 per cent to account for the spreads that exist in many small-cap stocks, the decade-long total return falls to a less explosive 162 per cent.

Picking through the wreckage of last year’s screen selections, a couple of themes stick out.

Most notable is what can only be described as a comprehensive exposure to the UK property market, via the estate agent Belvoir (BLV), Scottish housebuilder Springfield Properties (SPR), two commercial property landlords (the Impact Healthcare (IHR) and Warehouse (WHR) real estate investment trusts) and the brickmaker Michelmersh (MBH).

A year ago, these businesses were in good shape, buoyed by strong demand, manageable debts and forecasting dividend growth. And in some cases, this picture endures. Last week, the management of Michelmersh said they expected revenues and profits for 2022 to be ahead of market expectations, despite a “more challenging” trading environment. Analysts predict dividends will creep up this year and next, albeit at a slower pace than underlying earnings, given competition for free cash flow from the acquisition of smaller peer Fabspeed and the launch of a share buyback programme.  

But investors are clearly downbeat on the prospects for anything construction and property-related in 2023, especially if the last few years' gains have been even partly fuelled by cheap debt.

That likely explains the nosedive in the shares of Springfield and the previously high-flying Warehouse Reit. Indeed, although the trust's management recently signalled tenant demand for warehouse stock was proving "resilient", they have spent the past year deploying debt to grow the portfolio at a time when interest rates have been climbing rapidly. That has presaged a mark down in analysts’ earnings expectations, and a jump in leverage that means it no longer passes our screen’s five times interest cover ratio test.   

More broadly, the screen’s criteria hunt for stocks with solid dividends and decent growth. The tests that are conducted on constituents of the FTSE All Small and Aim All-Share are as follows:

■ A historic and next-12-month forecast dividend yield among the top half of all dividend-paying stocks screened (see below for changes to this criteria).

■ Dividend cover of 1.5 times or more.

■ Three-year dividend compound average growth rate (CAGR) of 5 per cent or more.

■ Three-year EPS CAGR of 5 per cent or more.

■ Average forecast growth for the next two financial years of 5 per cent or more.

■ Interest cover of five times or more.

■ Positive free cash flow.

This year just two stocks – South African PGM miner Sylvania Platinum (SLP) and legal services group RBG Holdings (RBGP), both of which are Aim listed – passed all seven of the screen’s tests. In the interests of increasing the number of selections, I have admitted stocks whose EPS covers dividends per share at least 1.3 times – so long as the interest cover ratio is at least seven. That throws up another four stocks, including one constituent of the All-Small index (and another law firm), DWF (DWF).

My hunch is that this should be a better year for small-cap value stocks. While the economic outlook remains clouded in uncertainty, the past year’s sell-off means entry prices for smaller companies have lowered far more sharply than their larger counterparts. Despite posting annualised returns of 8.5 per cent since 1990, according to French’s data, smaller value stocks in developed markets outside the US are now trading at some of the widest discounts to large stocks in decades. That’s worth paying attention to.

A table with fundamentals relating to all the stocks highlighted by the screen can be found at the end of this article, and the download link below.