Our high yield small cap screen is struggling – here's why

What I didn’t expect was for it to inspire feelings of mild dread. But in the past few months, that’s what has happened, as the ever-worsening condition of this issue’s screen – our High Yield Small Caps method – loomed out of the table with each weekly refresh. In the pre-dashboard days, a screen’s performance was only revealed at the end of a year. Now, the real pain spots are documented in near-real-time.

While studies have shown that over-checking one’s investments increases our innate tendency towards loss aversion, thereby leading to over-trading and poor decision-making, we are bound to our screen rules. That means annual refreshes, sticking to a methodology and avoiding the temptation to meddle.

Fortunately, most of the screens have held their own on both a short- and long-term basis. Even the High Yield Small Caps methodology is ahead of its (admittedly rather feeble) benchmarks over one decade, and since we started running it towards the end of 2012. My concern, however, lies in its dreadful recent run.

After a dismal outing for 2021’s selections – in which all seven stocks made a loss, even after including dividends – the 2022 batch managed to fall even harder, notching up a 34 per cent total loss in the year to 21 November. Despite banking a 27 per cent gain from law firm DWF, which agreed to a 100p takeover in July, double-digit declines for our other stocks (including near-total collapses in fellow professional services outfit RBG (RBGP) and the now-delisted outsourcer iEnergizer) amounted to collective failure.

2022 Performance

Source: LSEG

Not only was this more than 35 percentage points behind the FTSE Small Cap index, but it meant that the screen fell well short of that weakest of benchmarks, the Aim All-Share index. The net impact on the screen’s all-time performance has been to drag it down to 121 per cent, less than a third of its all-time peak of 397 per cent in August 2021. Although that hugely diminished return still equates to a compound annual growth rate of 8.1 per cent, that’s not much compensation for substantially higher risk and volatility.

In fact, things look a lot worse if we inject a bit of real-world trading friction. 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 reflect the spreads that exist in many small-cap stocks, the all-time total return falls to just 68 per cent.

A year ago, I suggested that record discounts in smaller companies compared with their larger counterparts meant 2023 could be a better year for small-cap value. Well, so much for hunches.

One potential deficiency in the screen is that it asks for a lot. By focusing on yield, it is interested in value, albeit tempered by the discipline of a dividend policy. But it also aims to balance this with a couple of classic quality tests, as well as evidence of income generation and the expectation of growth. Like many screens in our stable, the latter criterion means relying on analyst forecasts, which can often prove shakier at the lower end of the market.

As with years past, the tests were a little too tough for London’s small caps. Even after screening both indices, just three – recruiter Robert Walters (RWA), cashed-up oil and gas group Serica Energy (SQZ) and law firm Knights (KGH) – met the original criteria in its entirety.

In the interests of widening the pack, I have admitted stocks whose per-share earnings cover dividends at least 1.3 times – so long as the interest cover ratio is at least seven. I’ve also diluted the forward EPS growth test to capture stocks that have a positive outlook over the next two years. Doing so adds three more names, each of which has crept onto other screens in the past year.

So what’s the prognosis for the coming year? After such a horrible run, it’s tempting to throw in the towel. But that would be to ignore the strong returns that have accrued to several of our other small-cap focused screens, most notably our Jim Slater-inspired PEG Small Caps and Small Caps on Steroids methods.

Perhaps a new market paradigm is leading to a wider dispersion of both business performance and stock price returns, and that this is most acutely felt in the market’s lower orders. As ever, it can be hard to offer a concrete summary of an entire market, not least when recent research from small-cap specialist Verdad Capital complicates everything by suggesting the quality of European small caps has risen slightly over the past decade.

Another startling aspect of this week's screening process was the drop in the number of constituents now listed on Aim. According to the London Stock Exchange, the ranks of the junior market are now 10 per cent below its recent December 2021 peak. Most of this decline has occurred in recent months, as the appetite for IPOs has disappeared and takeovers – sometimes at marked-down valuations – have picked up.

Whether a smaller pond will improve the prospects for this disappointing fishing expedition will be more apparent in a year’s time. Until then, 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.