Nine high-quality small-cap plays

However, this column seeks to present screens on a warts-and-all basis providing readers with the full range of stock ideas each trawl of the market throws up. So Utilitywise’s torrid loss during the last 12 months has dragged the performance of the screen to below that of the index, although a 27.5 per cent total return is still none too shabby nevertheless. Indeed, the same lack of scrutiny that lets problems with smaller companies be overlooked, also presents opportunities to find hidden gems, as reflected by some big individual gains from last year’s selection of 10 stocks.

2016 PERFORMANCE

Source: Thomson Datastream

This is one of the screens I run that I feel is worth looking at on a long-term buy-and-hold basis given its emphasis on trying to find 'quality' companies. From this perspective, the results look encouraging, especially given that the underperformance of the 2014 screen in its first 12 months has since been reversed.

BUY-AND-HOLD PERFORMANCE

Source: Thomson Datastream

On a cumulative basis (based on a notional annual switch between the screen’s share picks on the date of publication) the performance over the last five years also looks good with a total return of 147 per cent compared with 83 per cent from a 50:50 combination of the FTSE Aim All-Share and FTSE Small Cap indices – the indices from which this screen selects shares. If I factor in a 2 per cent charge to reflect the high dealing costs associated with smaller company shares, the cumulative total return drops to 123 per cent.

Source: Thomson Datastream

This screen looks at a number of classic measures of “quality”. It also tries to avoid shares that look expensive and therefore may present a significant risk from de-rating if they disappoint. The screen also avoids very cheap shares in case they are value traps. The main valuation measure – the genuine value (GV) ratio – takes a company’s valuation, adjusted for net debt, against its earnings and compares this with expected forecast growth and the historic dividend yield. Essentially, this is similar to a classic price-to-earnings-growth (PEG) ratio with a couple more bells and whistles.

The full criteria of the screen are as follows:

■ PE ratio above bottom fifth and below top fifth of all stocks screened.

■ Lower than median average GV ratio.

■ Earnings growth forecast for each of the next two years.

■ Interest cover of five times or more.

■ Positive free cash flow.

■ Market capitalisation over £20m.

■ Higher-than-median average return on equity (RoE) in each of the last three years.

■ Higher-than-median average operating margin in each of the past three years.

■ RoE growth over the past three years.

■ Operating margin growth over the past three years.

■ Operating profit growth over the past three years.

Nine stocks passed all the screen’s tests this year and these are set out order of lowest (cheapest) to highest GV ratio in the table below. I’ve also taken a closer look at the share with the lowest GV ratio in the table (Billingon), the share at with highest GV ratio (ULS Technology) – although all shares have low GV ratio’s relative to the wider market – and the share slap bang in the middle of the table.

NINE HIGH QUALITY SMALL CAPS

Source: S&P Capital IQ

Billington

When investing in small caps, an important consideration is a share’s liquidity – the ability to trade in size without moving the price or having to stomach a wide bid-to-offer spread. This is a particular issue with structural steel and construction-safety equipment group Billington (BILN). Not only is the company’s market capitalisation teeny, but only about a third of the shares constitute the so-called 'free float', with the rest held by three major shareholders.

That said, for anyone able to get their hands on shares at close to the quoted price, the micro-cap company offers some clear attractions. Despite its diminutive market capitalisation, Billington is an established player in the structural steel market, boasting a 70-year history and a top five market position. That said, the market is dominated by Severfield.

Billington started this year with strong order books across all its divisions stretching into the first quarter of 2018. Conditions have been helped not only by more buoyant demand from the construction industry, but also by the failure of a number of small rivals over recent years.

What’s more, prospects for operating margin growth looks exciting following an increase from 5.4 per cent to 6 per cent last year. Further improvements are expected to come from an ongoing efficiency drive and a focus on winning larger, more complex contracts where Billington faces less competition and can therefore command better prices. And while past margin peaks are unlikely to be recaptured overnight, a trend gradual increases in profitability should have some way to run, based on the 2009 margin peak of 9.3 per cent.

Rising margins should amplify the benefits of recent investment in top-line growth. Having operated at or near full capacity throughout 2016, the second half of the current year should see major works begin at a state-of-the-art site that Billington acquired in December 2015. The company had been waiting for a number of tenants to vacate the site, but should now be able to focus on increasing its capacity and developing products to take it into new markets.

Investment in the new site is expected to increase capital expenditure in coming years, but cash generation should remain solid. Coupled with the robust balance sheet this encouraged management to hike the dividend by two-thirds last year from 6 to 10p. That makes Billington’s shares look an attractive yield play, with broker WH Ireland predicting an 11p payout in the 2018 financial year and year-end net cash of £5.8m. A further plus is that non-executive director Alexander Ospelt, a representative of the company’s two largest shareholders, spent £16,000 on 6,500 shares in June at prices of 244p and 259p. However, it should be noted that another non-exec, John Gordon, was selling earlier this year as well as last year.

Last IC View: None

 MJ Gleeson

With signs that house-price inflation is slowing, it’s possible that housebuilders’ margins may finally be set to top-out following an incredible ascent that has helped propel several years of febrile earnings growth in this highly-cyclical sector. However, with houses still in short supply, disciplined deployment of capital by the industry, mortgages plentiful and cheap, and unemployment low, housebuilders generally still look to be on solid foundations.

In this environment, MJ Gleeson (GLE) looks like it could be in a particularly good position to grow both earnings and dividends. The company specialises in in building very low-cost houses. It takes on problem sites, often in areas that have seen very limited historic house-price inflation, and uses its strong contractor relationships to build properties locals can actually afford. The model means its buyers are very dependent on the government’s Help to Buy scheme, so news of a review of the scheme, which was due to be curtailed in 2021, could be significant. However, suggestions that the review may focus on introducing means-testing may not be a huge concern for Gleeson given the low income of its buyers. In the meantime, demand for Gleeson’s product is high and the specialist nature of the work keeps competition at bay.

The attractive market dynamics have encouraged the company to grow its output. Having hit a target for 1,000 completion in a year in the 12 months to June 2017, the company has said it now plans to double output to 2,000 homes over the coming five years. To this end, the company grew its land bank by 25 per cent last year to 11,588 plots. Strategic land sales have also been strong.

The planned output growth means that while broker Liberum predicts operating margins will moderate in coming years from the 18.5 per cent pencilled in for the 12 months to June 2017, it still expects to see EPS rise substantially. Indeed, EPS is forecast to grow by over a third in the three years to June 2020 to 63.3p. What’s more, rising earnings and solid cash generation should see the dividend yield also grow, with 22p pencilled in for next year, followed by 24p then 26p.

So, while a moderation in house price growth as well as rising build costs could put pressure on margins, MJ Gleeson has a good chance of continuing to prosper if the cycle does not turn more violently than expected.

Last IC View: Buy, 587p, 27 Feb 2017

ULS Technology

When the housing market is slowing, conveyancing is not normally a good line of work to be in given its direct link with transaction volumes. However, the prospect for huge market share gains means ULS (ULS) represents a play on the industry that could buck any negative wider trends. The company is what is popularly termed a 'disruptor'. Its principal activity is a business-to-business (B2B) online conveyancer comparison services. ULS sources work through mortgage lenders, which can then compare the offerings of solicitors signed up to the ULS platform that operate in the area of a specific transaction. ULS makes its money by taking a fee from the company that wins the conveyancing work.

Importantly, ULS’s service is popular with clients, allowing it to continue to forge new relationships with lenders – challenger banks are a particular focus. This underpins management’s ambition to increase its share of the conveyancing market from 2.3 per cent to over 10 per cent, measured by referrals as a percentage of total transactions.

While B2B conveyancing income makes up the bulk of the business, ULS is also expanding into new parts of the market.  It is extending the range of services it offers, including a new will writing service. It is also buying companies to widen the areas from which it sources conveyancing jobs, such as estate agents and individual home owners.

Robust cash generation is helping to support the buy-and-build strategy. Indeed, despite spending £8m on acquisitions last year (including a £1m deferred payment) and paying out £1m in dividends – together these dwarfed reported post-tax profit of £2.9m – the group still finished its financial year to the end of March with just £3.4m of net debt compared with net cash of £2.9m 12 months earlier. While deferred acquisition payments sit on the balance sheet at £2.6m, the relatively low debt level means more deal-making remain on the cards.

There is plenty to be excited about with ULS, but a slowdown in transactions is a clear negative. Not only does a weakening end market increase the risks of cracks appearing in the growth story, but pursuing an acquisitive strategy at a time when end markets are declining increases risks associated with integration. Still, the potential to win market share and branch out into new areas is exciting.

Last IC View: Buy, 122p, 28 Jun 2017