New momentum offers hope for our small-cap stock screen

What was remarkable about this mini rally wasn’t just its force or geographic breadth, but the size of stocks that came along for the ride. In the UK, while the blue chips of the FTSE 100 index recorded a handy 8.2 per cent total return, the more domestic FTSE 250 – where market capitalisations range from around £4bn to £400mn – posted a gain of 17.4 per cent.

Head down the pecking order, and the momentum didn’t let up. The FTSE Small Cap index, which includes those main market firms too small for the FTSE 350, climbed 13.2 per cent in simple price terms, matching the rise in the Aim All-Share. This was after the junior market recorded a two-year peak-to-trough decline of around 49 per cent, its biggest drawdown since the 2008-9 financial crisis.

Since the new year, perhaps supported by newfound animal spirits in the M&A mid-market, small caps have rather unconvincingly held their ground. But while the relief will be welcome to suffering shareholders, the past couple of years have raised serious doubts around the ability of many smaller listed shares to preserve their value.

And though it always feels odd to lump such a disparate group of companies into one bracket, the disconnect from larger, more liquid shares has clearly been a thing, and in some cases indiscriminate. Though that has created a fertile ground for value fans with distant horizons, small caps have been a horrible place to shelter.

It wasn’t meant to be this way. Small caps, given their lower liquidity, heightened economic sensitivity and greater bankruptcy risk, tend to come with higher volatility. But over time, academic studies have shown that this should be compensated for by higher returns. That should provide some appeal.

Why then, did markets appear to lose a sense of proportion between 2021 and the autumn of 2023? In the middle of 2022 – with the slump in smaller stocks in full swing – the team at US small cap specialists Verdad Research pointed out that to asset allocators, the image in the rear-view mirror was horrid. Heightened volatility and lower returns meant that investors in the S&P 600 small cap index were getting half the return per unit of volatility as buyers of the S&P 500.

This self-reinforcing doom loop – the urge to sell small caps because of their relative unattractiveness – has, I would argue, been echoed in the UK market, albeit with the caveat that the alternatives (large caps) haven’t provided the blistering growth seen in America. However, sometimes, investors must make do with prices and stick with the fundamentals.

Our Cheap Small Caps screen, which adapts the methods of famed contrarian investor David Dreman, is big on those fundamentals. Though the screen likes bargains, its tests insist on a range of strong stock classic measures, from limits to balance sheet gearing, to good near-term liquidity, operating margins and dividend cover, that should help to avoid the most obvious reasons for cheapness.

Alas, the screen’s 2023 picks failed to overcome the largely dour sentiment toward small caps over the past year, posting a painful negative total return of 14.6 per cent.

Faced with this challenge to the strategy, what would Dreman do? One retort would be to grin and bear it. Though he has never been known as a big fan of small-cap stocks, Dreman’s 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. By applying a value-based investing approach to stocks listed outside the FTSE 350, the hope in 2024 is that this methodology can find companies which have been doubly overlooked.

Last year’s fall means that in the nearly 11 years since launching the screen, its annually-refreshed selections have posted a total return of 132 per cent. While its ideas are meant as a basis for further research rather than a ready-made portfolio, if we factor in a chunky 2 per cent annual dealing charge to reflect real world costs of trading in small caps, then the return falls to 86 per cent. That’s better – but not by much – than the 68 per cent return from its FTSE Small Cap/Aim index benchmark.

The screen follows a two-stage process. Initially, the cheapest quarter of FTSE All Small and Aim 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 our 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, as this 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 continued exodus from the lower ranks of London’s equity markets means the total combined pool of stocks in the FTSE Small and Aim indices is down 11 per cent, to 936. Despite this, the screen was more successful in its hunt for cheap stocks that meet all criteria. Out of the 11 to make the grade overall, seven tick at least one measure of cheapness and all eight tests.

Though that’s probably enough to go on, in the interests of sector diversification I have allowed stocks to fail one test so long as they tick at least two measures of cheapness. As with last year, their numbers include companies which some investors will likely consider cheap for a reason, though I would argue that Dreman’s tests go further than many of our screens in seeking a balance between prospects, classic signs of quality or defensiveness, and business resilience.

Further details, including the failed tests and measures of cheapness, are in the table below, and in greater depth in the downloadable spreadsheet.