Eight bargain small-cap stocks

For one, they are usually less liquid, meaning their prices are more susceptible to market swings than blue-chips. Relative size also plays a role: when the economic backdrop darkens, smaller companies tend to suffer to a greater degree than their better-resourced and sometimes more entrenched larger peers. As a result, bankruptcies are more common the further you head down the food chain.  

Then there is perception. While not every small company is run for growth, the prospect of above-average market expansion and business scaling is a big reason why investors think small is beautiful. Whenever the rug gets pulled from this growth narrative, sentiment often sours more quickly than it does for large mature companies, which can even get a bounce from so-called “flights to safety”.

In other words, the compensation for greater risks should be better prices and cheaper valuations. Then again, there is a good reason why investors should want to buy small-cap stocks, even with their greater volatility: as the academics Eugene Fama and Kenneth French showed in a landmark 1993 paper on risk factors, small-caps have historically justified their lower valuations with better risk-adjusted returns.

Combine this observation with a screen for cheapness and other signs of operational quality, and investors can give themselves a good chance of buying – at a discount – leaner businesses with greater market growth prospects and greater motivation for efficient capital allocation.

At least, that’s the theory behind our Cheap Small Caps screen, which uses the methods of famed contrarian investor David Dreman to pick out companies overlooked by the market. Although Dreman wasn’t known as a big fan of small-cap stocks, his investing philosophy – like that of Benjamin Graham or Joel Greenblatt – shares the belief that markets can be deeply irrational, and that this often leads to disconnects between a company’s stock price and its overall value.

Whether it be market liquidity, a lack of analyst research or investor attention, disconnects can often be found at the junior end of the market. While Dreman’s faith in forecasts as a reliable proxy for a company’s growth prospects will at times come a cropper, his insistence on a range of strong stock fundamentals – from limits to balance sheet gearing, to good near-term liquidity, operating margins and dividend cover – means he is keen to disregard the most obvious reasons for cheapness.

In a rough year for the size factor, the screen’s 2022 picks went on a characteristically wild ride and finished by posting a negative total return of 4.8 per cent. While this was better than market capitalisation-weighted returns from Aim, it fell short of the screen’s benchmark, which is a blend of both the Aim All-Share and FTSE Small Cap indices.

In the decade we have been running the screen, its selections have posted a total return of 172 per cent. While its ideas are designed as a basis for further research – rather than an off-the-shelf portfolio – if we factor in a chunky 2 per cent annual dealing charge to reflect real-world costs of trading in small company shares, then the headline total return falls to 122 per cent. That’s better, although not by a country mile, than the 81 per cent return from our FTSE Small Cap/Aim proxy benchmark for smaller UK-listed companies.

The screen follows a two-stage process. 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 is the most subjective test, and may be distorted by thin analyst coverage or an abundance of corporate brokers talking up the near-term earnings prospects of their clients). 

■ 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 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 was a lot less successful in its hunt for cheap stocks that meet all criteria. Just three companies – home products specialist and 2021 screen selection Up Global Sourcing (UPGS), building merchant supplier Lords Group Trading (LORD) and online bathroom retailer Victorian Plumbing (VIC) – ticked at least one measure of cheapness and all eight secondary tests.

Given both the low hit rate and the lack of sector diversification in these businesses, I have allowed stocks to fail one test so long as they tick at least two measures of cheapness. Among them are companies that some investors will consider to be cheap for a reason.

These include North Sea gas producer Serica Energy (SQZ), for whom 2022 was a marquee year for profits, as an increase in production coincided with surging market prices and led analysts to pencil in a near-quadrupling in net income to £304mn. Now, the group must handle a mixture of sharply lower (if no less volatile) spot prices and an unpredictable political attitude to windfall taxes.

The market also has its reasons to doubt the likelihood of good newsflow from Speedy Hire (SDY). Two days before I ran the screen, shares in the tool equipment leasing business sank after executives disclosed they could not account for around 10 per cent of assets, raising big questions around internal controls and security, and the validity of past audits and accounting disclosures.

Screen returnee Watkin Jones (WJG) is another stock where confidence has been in short supply. On 4 October, in the teeth of an economic crisis sparked by the Liz Truss government’s mini-Budget, the build-to-rent housing developer told investors that market volatility had resulted in a delay to two forward sales and warned that full-year operating profits were likely to come in 10 per cent below already marked-down consensus estimates.

Then again, current sentiment isn’t something our Cheap Small Cap screen cares about. On the surface, its selections are solid businesses whose valuations don’t match up to average return expectations. Further details – including failed tests and measures of cheapness – are in the table below, and in greater depth in the downloadable spreadsheet.