Two cheap small caps

Regular readers of this column may have picked up on the fact that I’m having to help a number of the screens I cover box clever around the Covid-19 crisis. The nature of the economic upset that has accompanied the pandemic means many of the fundamentals sought by the screens have been temporarily thrown off kilter. Given that trading in 2020 is likely to prove an aberration for many companies rather than being reflective of a longer-term trend, I think adapting screens to the circumstances is the right thing to do.

But I am only prepared to take changes to screens so far. Essentially, I think the criteria used needs to stay true to the broad objective of the strategy a screen is trying to embody. That being the case, I’ve hit a bit of a brick wall with my Cheap Small Caps screen, which is based on the investment approach of famous American contrarian investor David Dreman. 

Rather than torture this screen beyond all recognition, I’ve decided to just accept that the output from the screen this year is low. Indeed, only one stock can pass all the screen’s tests. Even when I waive a further test which I believe lockdown will have made it particularly hard for value stocks to satisfy (year-on-year earnings growth in the latest six-month period) I only get one more stock qualifying. 

Indeed, the biggest problem for the screen is that many of the valuation metrics it uses are backward looking and these ratios are currently looking back at a truly awful period of trading. What this means is that shares look expensive compared with the recent past, but only because the recent past reflects an unusually poor period of performance. Still, Dreman had a lot of criticism for relying on forecasts and produced a seminal study on how unreliable they are. Bearing that in mind, I’ve decided to stick with the backward-looking ratios in this case.

The good news is that the stock that has managed to tick all the screen’s boxes looks interesting and makes a good study into a type of 'economic moat' (competitive advantage) that is often very easy to overlook: business process.

Before getting onto that, though, a quick look at the screen’s performance.

After clocking up a 57 per cent gain last year, the cumulative total return from the screen stands at 138 per cent compared with 95 per cent from a 50:50 split of the FTSE Small Cap and FTSE Aim All-Share index. While the screens are meant to provide ideas for further research rather than off-the-shelf portfolios, if I add in a notional 2 per cent annual dealing charge, the total return drops to 103 per cent.

The stock passing all the screens tests is home products specialist UP Global Sourcing. It was also the outstanding performer from last year's screen's picks.

By waiving the requirements for year-on-year half-year sales growth, Carr’s also managed to make the grade. Fundamentals relating to both companies are available in the accompanying table with, as usual, the downloadable version of the table providing extra details and a glossary of terms.

Two cheap small-caps

Source: FactSet

UP Global Sourcing

One of the less talked about ways a company can build a competitive advantage is through its business processes. The reason this area is not often given much attention is probably because 'process' can be hard to pinpoint from both a qualitative and quantitative perspective. Nevertheless, most investors intuitively know there is great value in business attributes such as: the effective management and development of staff; good product design; deep end-market knowledge; strong customer relationships; quality control; tight regulatory compliance; and savvy product sourcing.

Ultimate Products (UP) Global Sourcing (UPGS) is focused on all these things. And the company’s stripped-down, capital-light business model leaves few areas to look for competitive advantage beyond such business processes. 

UPGS’s brands, while recognisable to many UK consumers, are generally second tier and value focused. They therefore probably give it only a limited competitive edge. Meanwhile, its product ranges play to what’s popular rather than what is cutting-edge. In other words, the company does not seek to compete based on product specs and tech. It also outsources manufacturing. So it is not seeking to create bespoke manufacturing procedures to entrench it as the lowest-cost competitor. 

The dynamics of shareholder value creation for UPGS therefore chiefly depend on business processes (designing, selling, sourcing and shipping) to ensure it is creating products consumers want and turning its working capital into cash as quickly as possible.

The Oldham company began life in 1997 selling clearance products from the US before moving into private label products. Founder Simon Showman along with Andrew Gossage run the business and hold stakes of 23 per cent and 10 per cent, respectively.

UPGS moved into branded goods in 2009 when it bought ironing-board brand Beldray for £200,000. It has gone on to grow Beldray into a £33m sales (28 per cent of the group total) multi-product homewares business. Other brand acquisitions with similarly low price tags have followed, including German kitchen brand Petra, which was bought for €100,000 in February. Since 2011, the company has also sold products under licence through the Salter and Russel Hobbs brands. Last year these licensed brands were the group’s next two biggest by revenue at 22 per cent and 10 per cent of total sales, respectively. 

In 2020, a total of 70 per cent of sales in all came from what the company regards as its 'premier' brands and 84 per cent from across all 'key' brands.

UPGS’s sources products through a network of over 270 suppliers, mainly in China. Products are shipped to the UK and increasingly Europe, where sales have grown to 36 per cent of the total, with Germany accounting for the largest continental market at 9 per cent of sales.

Given the company’s operating margins are relatively low, 7.9 per cent last year, and its key capital requirement is working capital (inventories and receivables have average about 80 per cent of total assets over the last two years), the speed at which it can turn inventory into sales and then cash is paramount.

Fortunately, UPGS seems to be good at doing this. So-called capital turnover (sales as a percentage of average capital employed) has been about five times over the three years since float. This means those relatively modest margins have resulted in a high return on capital employed (ROCE); 37 per cent last year. ROCE measures a company’s operating profit as a percentage of capital employed and is a useful indicator of business quality. 

However, there are risks associated with UPGS’s business model, a number of which are outside its control. One risk is that demand for the company’s products is likely to drop during a recession. That said, the peculiarities of lockdown means it seems to have dodged this particular bullet last year.  

Revenues in the year to the end of July 2020 were only down 6.1 percent. The fall was largely the result of the forced closure of some customers’ stores that were classed as non-essential. But more generally, the products UPGS specialises in were in demand from home-bound consumers. Its biggest product areas are: small domestic appliances accounting for a third of sales; housewares at 24 per cent; audio 15 per cent; and laundry 11 per cent. First-half sales in the current financial year, meanwhile, rose 11.4 per cent.

UPGS’s focus on 'value' also may offer it some protection against economic downturns.

Another risk associated with UPGS’s model is its reliance on overseas suppliers, particularly given their concentration in China. The pandemic has caused some disruption to supply chains and a spike in container rates. However, encouragement can be taken from the fact that UPGS met these challenges well. The fact its products come from outside the EU also means Brexit should also not be too much of an issue.

UPGS also has large powerful customers, which should be a big consideration for would-be investors. This risk came home to roost soon after the company floated in March 2017 when one customer renegotiated terms and another took production in-house. As a result, in 2018 revenue fell 20 per cent that year to £88m while underlying pre-tax profit tanked 44 per cent to £6.5m. A weak UK general merchandise market added to the woes. 

A fair bit has happened since to diversify the customer base, with UPGS’s dependence on its two largest customers dropping from almost half of sales in 2018 to just over a quarter last year. The type of retailer it sells to has also changed, with reduced dependence on discount stores (down from 56 per cent in 2018 to 43 per cent in 2020) and more products going to supermarkets (up from 15 per cent to 27 per cent). 

Online sales are also growing fast, aided by changing shopping habits during lockdown. These have almost doubled as a proportion of the total since 2018 from 8.6 per cent to 16 per cent in 2020. Inroads into Europe have been impressive, too. The 36 per cent of sales to the region in 2020 compares with 27 per cent two years ago. Europe could provide a major opportunity for long-term growth.

The encouraging progress made by the group despite the challenges of the pandemic has been reflected in the record of broker forecast upgrades over the last year. According to consensus data from FactSet, forecast earnings for the next 12 months are 21 per cent above where they stood 12 months ago and up 8 per cent over the last three months. The latest upgrades followed a first-half trading update in February.

Given there are some inherent risks with this business, it is encouraging that the balance sheet looks in good nick. Average debt stood at £9.9m in 2020 (big seasonal swings are to be expected). This also puts UPGS in a good position to continue to buy and invest in brands that it thinks it can work its magic on. 

Despite a a strong recovery since last March, the shares do not look expensive, with an enterprise value of less than one times forecast sales and a low teens forecast price/earnings ratio. There is the potential for a further re-rating if UPGS can avoid nasty surprises and investors start to show more appreciation for the hard-to-pin-down process-based competitive advantage that appears to underpin impressive ROCE. The fact that the company requires little capital beyond the working capital tied up in its product cycle also means self-financed growth could drive gains. 

That said, while the company seems to be working well to reduce risks associated with its powerful client base and cyclicality, these factors are likely to put a ceiling on how high a rating investors are likely to want to put on the shares.