'Small Caps on Steroids' goes stratospheric

In Going Infinite, his new book on the meteoric rise and very painful fall of Sam Bankman-Fried, writer Michael Lewis dedicates a chapter to the FTX founder's time as a trader at Jane Street Capital.

A few details about this early career stop jump out, including a hiring approach that prefers maths whizzes to Wall Street archetypes, and the firm’s emphasis on technology and quantitative-led strategies. As Lewis puts it, these strategies often amounted to “looking for weighted coins to flip”, or small inefficiencies in markets that could be indefinitely exploited for huge, repeatable profits.

Because of this, Bankman-Fried and his fellow traders were judged not only on how well they did, but on their ability to explain why they did well. The use of big data and computing power might have replaced traders’ gut instinct for the risk-reward trade-off, but they needed to show their working and explain how it could be automated, freeing up their time to pursue other “weighted coins”.

“A great trader at Jane Street was not a great trader unless he could explain why he was a great trader, and why some great trade existed,” Lewis writes.

At this point, a bit of disclosure is warranted. While the screens and stockpicking methods that appear on these pages are often based on documented and data-led insight into how markets and investors have behaved in the past, each set of selective criteria is well understood. Arguably, any edge these strategies might have once possessed ought to have disappeared long ago.

That’s not what the record shows. Our regularly updated dashboard of our 33 annual screens shows that these strategies have largely managed to beat the market – defined as having a better average annual total return than their benchmarks – over one, five and 10 years.

But that alone isn’t going to win us a job at Jane Street (starting salary $300,000). One reason for this, at least in the opinion of the screens’ current steward, is that it’s not always possible to explain why a strategy has done well.

This week’s screen, half-jokingly named Small Caps on Steroids by my predecessor Algy Hall, is a case in point. Over the past year, it has clocked up a 35 per cent total return, soaring past the 6.8 per cent loss from its yardstick, a 50-50 split of the FTSE Small Cap and Aim All-Share indices. While this performance comes with a big caveat (more on which below), it came on the heels of another barnstorming 42.8 per cent outperformance during the previous year, which together with a resilient showing in 2020-21 makes for a pattern. It also means the screen is up more than 90 per cent in three years, making it the best-performing screen in our stable over that time.

The thinking behind Small Caps on Steroids stems from a 2015 research paper by Brian Chingono and Daniel Rasmussen of Verdad Capital, which arrived at the contrarian observation that “smaller, cheaper and more leveraged stocks that are already paying down debt” can be a source of alpha. Although the paper focused on US small caps between 1965 and 2013, it appears the trend has its echoes even in the largely depressing context of UK small caps, post-pandemic.

I say “appears” because I’m still not entirely sure how to explain the screen’s success. One possibility is that since interest rates started to tick up, investors have adopted an extra-bearish default position towards small companies with high levels of pre-existing debt. If the position is contradicted, and evidence emerges of rising earnings and strengthening balance sheets, then it might be viewed as doubly positive.

However, that view is somewhat undermined by the screen’s search for stocks whose asset turnover and debt positions are already improving. That's to say it's not as contrarian as it could be. Plus, by filtering for companies with low enterprise value to Ebitda ratios, it is at least focused on signs of positive (if underlying) earnings.

Another theory is that the screen’s excellent run is down to its heightened risk, reflecting the high concentration of its picks. Last year, for example, just three companies passed each of the screen’s tests, one less than the 2021 cohort.

This included one very high-risk stock in Savannah Energy (SAVE), the best performer in the 2021 screen and the subject of the caveat mentioned above. A few weeks after it made our 2022 screen, trading in Savannah’s shares were suspended after the oil and gas firm announced a $1.25bn reverse takeover of a portfolio of assets in South Sudan*. Since then – and though the company has continued to report financial results – the shares have stayed suspended, and the assets in Chad have hit a major problem. As such, the shares’ 1.6 per cent rise in our screen is doubly hypothetical.

The other two fared much better. Finsbury Foods (FIF) is up after accepting a £143mn takeover offer from DBAY Advisors, while construction outfit Kier Group (KIE) has rebounded from extreme precarity on the back of a sharp improvement in free cash flow and its order book. This, in turn, helped the group to cut gearing by more than half and record a tripling in post-tax profits in the year to June, paving the way for an imminent return to the dividend list after a four-year hiatus.

The past year’s monster rally brings the cumulative total return for the five years the screen has been running to 98 per cent, versus a 9 per cent loss from its benchmark indices, from which its selections are drawn. 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 75 per cent.

That equates to an annual compound growth rate of 11.8 per cent, which is pretty good. Higher volatility has been worth it.

Our screen’s full criteria 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, the screen has had more success in uncovering small, cheap, and indebted companies showing signs of operational improvement and balance sheet deleveraging. In all but one case (gold mining minnow Metals Exploration (MTL)) earnings are expected to rise over the coming 24 months. However, the list does include two firms – namely, convenience food producer Greencore (GNC) and legal services business Knights (KGH) – whose de-gearing has been slight over the past year.

Whatever those metrics point to, this year’s batch is up against some tough comparators. We’ll find out if they have the juice to match the screen’s excellent medium-term trend in a year’s time.

*This article originally incorrectly stated that the suspension was related to completion of the Chad deal.