Get them small and cheap

Year-by-year performance

Source: Thomson Datastream

That said, for most investors a screen represents a first step in an investment process – at least that’s the assumption this column makes for readers. A screening process effectively cordons off stocks that look as though they have the potential to meet a given investment objective before further research is undertaken to see if the candidates really stack up. With a value-orientated screen, there is always the potential to highlight shares that are cheap for a reason, often referred to as 'value traps'. This screen has certainly highlighted many stocks that fall into the value trap camp over the years, but it has also undeniably highlighted many big winners, too. The fact that stocks that have gone on to produce major upside have been a persistent feature in the screen’s results provides some grounds to think the screen should be regarded as of interest even if it also highlights its share of horrors.

In fact, by the standards of previous years, the biggest winner of the past 12 months, XL Media, which returned 63 per cent, did not look terribly noteworthy. But then again, neither did the biggest loser, Moss Bros, with a 43 per cent negative total return. All in all, the 8.2 per cent total return generated by the 17 stocks selected 12 months ago fell short of the 9.3 per cent from a 50:50 combination of the FTSE Aim All-Share and the FTSE Small Cap indices.

2017 performance

Source: Thomson Datastream

The cumulative total return from the screen in the five years I’ve run it is little better than the 50:50 blend of the Small Cap and Aim indices, standing at 65.0 per cent compared with 60.7 per cent. However, this is before considering dealing costs, which can be significant for small-caps due to wide bid-offer spreads. If I factor in an annual 2 per cent charge to try to capture this unfortunate reality, then the cumulative performance looks pretty lousy compared with the indices, standing at 49.2 per cent.

Source: Thomson Datastream

The Cheap Small Cap screening process is based on the approach espoused by contrarian star David Dreman, although he suggested the process as a way to search for shares in larger companies. The screen essentially looks for a balance between low valuation and attractive fundamentals.

Initially, the cheapest quarter of FTSE All Small and Aim All-Share 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 (PBV) or the genuine value ratio (GV). The GV ratio is similar to a standard price/earnings growth (PEG) ratio in comparing an earnings-based valuation with earnings growth potential, but it also factors in dividends and debt. Shares that appear cheap on one or more of these valuation measures must also pass the following tests (the tests vary slightly depending on what metric stocks appear cheap against):

■ Underlying year-on-year EPS growth in the most recent half-year period.

■ Forecast EPS growth in each of the next two financial years. For shares qualifying based on a low GV ratio, I have eliminated any companies with an average forecast growth rate over the next two years of over 50 per cent, as such strong growth could prove unsustainable.

■ A current ratio (net current assets/net current liabilities) of more than one, which 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 Mr Dreman's two quality tests: having operating margins better than 8 per cent or a return on equity of more than 10 per cent. Companies qualifying based on our GV ratio must pass both tests.

■ Dividend cover of 1.5 times or more, or above the three-year average.

■ For low PE ratio and low P/CF stocks, dividend yield must be above the median average.

This year’s screen has identified 24 shares. I’ve taken a closer look at two of the shares that appear among the cheapest selected by the screen on more than one measure.

Cheap small caps

Source: S&P CapitalIQ

Bonmarche (High yield, low PE)

The valuation of shares in Bonmarche (BON) falls into the too-good-to-be-true category based on a classic rule of thumb that says shares with yields over 7 per cent and price/earnings ratios of less than 7 should be viewed with suspicion. Like all generalisations, there are times when this rule of thumb can miss a trick, but it’s not a bad starting point for investors who want to avoid value traps. So, are there reasons to think Bonmarche may be one of the exceptions to the basic too-good-to-be-true rule?

It is hard to find much encouragement from recent trading, which has continued a negative trend established over the past few years. Over Christmas, in the 13 weeks to the end of December, Bonmarche reported a 5.5 per cent fall in sales, which included a near-10 per cent like-for-like drop at its established stores. What’s more, the group has a large rented store estate stretching to 324 shops. Sharepad puts an estimated value on its leases of £140m and the net cash position needs to be seen in context of this large debt-like liability. Lease costs were £19.7m in the last financial year.

However, new management is trying to implement a wide-ranging plan to revive Bonmarche’s fortunes. And while there have not yet been any signs of a decisive turnaround, there are some glimmers of hope. Online sales growth has been very strong, posting a near-30 per cent rise in the 13 weeks to the end of December. That said, online sales represent a small proportion of the total and were less than a tenth of first-half revenue.

The group’s bricks-and-mortar stores could stand to benefit from progress made revamping product ranges. This has been helped by efforts to improve the supply chain and create faster turnaround times on new products that should help keep ranges more “on trend” while reducing stock levels. Encouragingly, at the half-year stage, stock was at the lowest level in five years. Management believes having less stock in-store is improving the experience for customers looking through rails, as well as reducing the need to discount products and freeing up working capital to boost cash generation.

The company has also been keen to emphasise the “flexibility” of its store leases and in its last annual report revealed that less than a tenth of its operating lease commitments by value are more than five years. Other areas of focus include the group’s loyalty programme and an overhaul of its 20-year-old ERP computer systems.

Management appears to have a clear focus on making common-sense improvements to the business. Meanwhile, the target market of women of 50 years old and over is growing. However, the weak consumer environment and underwhelming recent trading means any investment now would need to be heavy on the 'hope' factor.

Produce Investments (Low P/BV, Low P/S)

The price investors are willing to put on shares tends to be significantly influenced by the perceived quality of a company’s earnings. Many factors can be regarded as having an influence on earnings quality, but the predictability of profits is high up on most investors' lists. On this front, any re-rating of shares in potato and daffodil producer Produce Investments (PIL) faces an uphill battle – with nature’s fickle hand dictating so much of the outcome of each harvest, Produce’s performance is very hard to forecast in any given year. What’s more, margins are low, with an operating margin of 4.7 per cent forecast for the current year by broker Shore Capital.

Produce has attempted to counter the inherent volatility in its business by diversifying. The group has diversified into daffodils, early-harvesting potatoes and a few years ago acquired the Jersey Royal Company. The group operates throughout the supply chain, from seed development, to growing, storage and distribution, which broadens its ability to pursue opportunities where they arise. The breadth of its activities in the UK’s £4.7bn potato industry also potentially puts it in a good position to branch out into the production and distribution of other fresh veg.

Encouragement can be taken from the group’s first-half performance. New customer wins, strong volume growth, falling raw material prices and operational cost controls all contributed to a sharp rise in first-half profit from £200,000 to £2.4m. That means potential delays to harvests caused by some extreme cold spells early in 2018 may prove less of an obstacle to the group meeting full-year forecasts than would otherwise have been the case.