Seven high-yield small-caps

Targeting this type of smaller company share has certainly proved lucrative for my high-yield small-cap stock screen. The last 12 months have marked a fifth year of outperformance (see table). All the screens currently boast good outperformance on a buy-and-hold basis, too. To be clear, no screen should be expected to outperform all the time, so this five-year streak should be considered a lucky run rather than a basis to expect unfettered outperformance forevermore.

HIGH YIELD SMALL CAP VINTAGES

Source: Thomson Datastream

The cumulative total return from the screen now stands just shy of 200 per cent (198 per cent to be precise), equivalent to a threefold return in five years. That compares with 105 per cent from the FTSE Small Cap, 60 per cent from the FTSE Aim All-Share, and 82 per cent from a 50:50 blend of the two indices which I use to benchmark the screen against (see graph).

Shares in small caps are often illiquid, which means the difference between the buying and selling price of a stock (known as the bid-offer spread in broker jargon) can vary considerably from the quoted 'mid' price. Any small-cap investment portfolio is therefore likely to be costly to run, especially if it is reshuffled every year, which is the notional basis on which my high-yield small-cap screen is assessed. If I factor in costs of 2.5 per cent a year, the cumulative total return from the screen drops to 163 per cent. It is satisfying to note, though, that the screen has done well when assessed on a buy-and-hold basis, which would avoid heavy dealing charges (see table above). This suggests the screen has been highlighting some good ideas for the long term.

Returns from the seven shares that passed all of last year’s screen tests were good overall, but they would have been exceptional were it not from the broadside dealt by Utilitywise’s share price collapse (see table).

2016 PERFORMANCE

Source: Thomson Datastream

I had suggested last year that despite getting a decent number of results that passed the full screening criteria, it was worth including a separate list of stocks that passed a weakened criteria. The weakened criteria was one that I’d used in previous years to bulk up the number of positive results due to a meagre output from the full-criteria screen. My logic for last year’s inclusion of stocks qualifying on a weakened criteria was that the high risks associated with smaller companies meant there was a virtue in having more diversity in the portfolio. While I haven’t factored these weaker-criteria stocks into the cumulative performance listed above, they did in fact perform better than the fully-qualifying stocks, principally because they didn’t have a Utilitywise-sized disaster among the picks (see table).

2016 WEAKENED-CRITERIA PERFORMANCE

Source: Thomson Datastream

The screen is conducted on the FTSE All Small and the FTSE Aim All-Share and uses the following criteria:

■ A dividend yield in the top third of all dividend-paying stocks screened.

■ Dividend cover of 1.5 times or more.

■ Three-year dividend compound average growth rate (CAGR) of 5 per cent or more.

■ Three-year EPS CAGR of 5 per cent or more.

■ Average forecast growth for the next two financial years of 5 per cent or more.

■ Interest cover of five times or more.

■ Positive free cash flow.

This year seven stocks passed all the criteria while a further 25 passed the weakened criteria, which allows stocks to fail one screen test as long as it is not the key dividend yield test. The stocks are detailed in the two tables below arranged from highest to lowest dividend yield. In addition, I've provided write-ups of three of the fully-qualifying stocks based on the shares at either end of the table along with the one in the middle.

FULL MARKS

NEARLY THERES

Source: S&P Capital IQ

Record

Dividends and capital returns are a key draw for investors in the shares of currency manager Record (REC). The company’s robust balance sheet means almost all Record’s earnings are being paid out as dividends at the moment. That’s likely to mean a 2.3p payout this year, equivalent to a near 5 per cent yield, with the first half of the payout going ex-dividend on 30 November (before print publication of this article). In addition to this, the company returned £10m to shareholders earlier this year through a tender offer which eliminated about a tenth of its share capital. Further capital returns look a distinct possibility based on the company’s policy of returning anything in excess of a buffer set at one year’s expected overheads.

The increase in foreign-exchange market volatility over recent years makes an attractive backdrop for Record’s business as it encourages more companies to hedge their currency exposure. Indeed, the company's assets under management have almost doubled since March 2012 and stood at $61.5bn (£45.9bn) at the end of September. However, the relationship between volatility and demand is not altogether straightforward. Dollar weakness has recently led to the loss of some dynamic-hedging clients, while others have switched to lower-margin passive-hedging services. Some of Record’s other higher-margin products have been gaining ground, though. Currency-for-return and multi-strategy mandates grew from $3.5bn to $4.7bn in the 12 months to the end of September, taking these more lucrative bits of business from 7 per cent to 8 per cent of assets under management (AUM).

While AUM is growing and some higher-margin products are attracting more interest, the company has also had to invest in headcount to keep service levels high and has opened a Zurich office to better serve clients located there. This investment, along with the workload associated with adapting to new regulations, led to a drop in the first-half operating margin from 33 per cent to 31 per cent. New regulations – MIFID II and European Market Infrastructure Regulation (EMIR) – may also end up making life too onerous for some of Record’s smaller passive-hedging clients which could mean some mandates are lost.

So, while overall there are reasons to be optimistic about the trading outlook for Record, there are also some potential bumps in the road. But the strong balance sheet and commitment to a progressive dividend policy mean the shares look an enticing bet for income hunters.

Last IC View: Hold, 47p, 20 Jun 2017

Photo-Me International

Photo-Me is using its strong cash flows and leading position in several markets to drive growth. The strategy could prove lucrative for shareholders in coming years.

The attractions of Photo-Me’s (PHTM) focus on automated instant services machines in niche markets is reflected in its high return on capital employed (ROCE), which last year stood at just over 24 per cent. Importantly, these tempting returns should, to some extent, be protected from competition by: the limited size of its end markets; the amount of initial capital investment needed; and the operational advantages of scale. The icing on the cake for the company’s fans, is that management believes there is the opportunity to make similarly lucrative returns from new investment over the next three years.

The scale of Photo-Me’s photo-booth business, which accounts for 59 per cent of the instant-service estate, has put it in a great position to invest in cutting-edge digital technology such as biometrics and 3D imaging.  As governments around the world move to address increasingly complex ID security issues, these innovations are expected to become an increasingly important competitive advantage that should drive market share gains and underpin price rises. Regulatory changes in France and Ireland are already playing to this theme.

The company is also using its existing network of engineers to roll out self-service laundries. These have been a big hit since they were introduced and offer higher-margins than photo booths. Last year the number of laundry units were increased by 50 per cent to 3,251. The expansion included a move into Japan – a region that is thought to have massive growth potential. The company also operates 50 launderettes and offers other laundry services.

Meanwhile, Photo-Me’s printing kiosks operation looks set to benefit from reduced competition from Kodak as well as rising demand as a result of increased smartphone use and photo-sharing through social media.

The company generates about 70 per cent of its profits from Europe, so the broad-based economic recovery in the region bodes well for prospects. What’s more, given the significant fixed costs associated with its business, any sales increases from its machines stand to have an outsized impact on profit. That suggests scope for significant upgrades if the group does indeed benefit from the economic tailwind. In fact, broker N+1 Singer calculates a 1 per cent sales increase is likely to translate into a 2 to 3 per cent rise in EPS.

The same broker also believes the market is currently overlooking the company’s growth potential and is forecasting a three-year compound annual EPS growth rate of 10 per cent, which is about double the consensus. In addition, the broker thinks the reality could be far better than its central forecast and views 18 to 23 per cent as a real possibility.

The high returns and potential for growth seem to justify the relatively high earnings multiple, and that’s before getting onto the attractions of the dividend, which is supported by a strong balance sheet and robust cash flows. Half-year results on 11 December may provide a hint to whether N+1 Singer’s punchy forecast are on the money.

Last IC View: Buy, 163.5p, 28 Jun 2017

RM

As the UK’s post-credit crunch taste for fiscal austerity has turned the screw on schools, schools supplier RM (RM.) has been forced to cope with several years of declining revenues. After peaking at £380m in 2010, last year’s revenues of £162m were back at 1999 levels. While last week’s budget provided little cause for celebration, RM’s shareholders can at least take some comfort from signs the rate of sales decline may be slowing (see chart).

However, while times may be tough, RM is working hard where it can. Despite a 7 per cent decline in turnover during the first six months of the year, underlying operating profits were stable thanks to improved margins. The company is also seeking to strengthen the most challenged part of its business – school resources. This division accounted for 35 per cent of sales last year and half of profit. RM is combining this operation with a similar business it bought for £64m from listed distribution company Connect and has also been looking to grow overseas sales.

The group’s results business, which provides technology for testing and marking, is the strongest performing part of the group at the moment. Meanwhile, sales declines in the group's ICT software and services arms have been more than offset by cost-cutting.

The recent acquisition from Connect is expected to mean the group ends its current financial year with net debt of £20m as opposed to the net cash figure in the accompanying table. The group also has a noteworthy pension deficit which stood at £22m at the half-year stage. More importantly, sales are expected to be higher and EPS is forecast to rise by 9 per cent by broker Numis. This should support an expected 10 per cent dividend boost to 6.6p – equivalent to a 4.1 per cent yield. What’s more, if everything goes well, the broker foresees the dividend rising to 8p by RM’s 2019 financial year – a 4.9 per cent yield. The current lowly PE ratio suggests there is definite room for the shares to re-rate if forecasts can be achieved, but the tough market conditions means this is no sure thing. On a more speculative note, the souring of public views towards austerity may signal the potential for a change in end-market conditions.

Last IC View: Buy, 180p, 11 Jul 2017