Small-caps offering genuine value and improving prospects

The change in question requires the screen to take account of recent revisions to brokers’ EPS forecasts. This screen previously only used forecast EPS growth and share price momentum as an indicator of sentiment and prospects. Given this strategy uses a valuation measure that focuses on earnings growth, looking at whether brokers are becoming keener on companies’ earnings prospects seems to fit with the overarching logic. Indeed, if earnings forecasts have been falling, the valuation metric used by this screen may be presenting a rose-tinted view, while the reverse may be true if forecasts have been rising.

My hope would be that the change will reduce the proportion of shares picked that come a cropper.  This has been an issue for the screen over the last year when three of the 22 shares selected a year ago delivered a negative total return of more than 70 per cent. Even with about 60 per cent of the shares picked by the screen outperforming the index, overall the screen underperformed, delivering a 7.4 per cent total return compared with 12.7 per cent from a 50:50 split between the FTSE Small Cap and FTSE Aim All-Share.

2017 performance

Source: Thomson Datastream

Over the five years I’ve run this screen it has delivered a total return of 112 per cent compared with 68 per cent from the combination of the FTSE Small Cap and Aim indices. However, that 112 per cent excludes any costs associated with portfolio reshuffles. But the significance of costs should not be overlooked, especially as dealing smaller-company shares can be expensive given wide bid-to-offer spreads. If I factor in a hearty annual charge of 2.5 per cent to try to account for these notional dealing costs were anyone to try to implement the strategy wholesale (screens are normally considered as principally a source of ideas for further research) the total return from the screen drops to 86.9 per cent.

Key to this screen is the search for companies that look cheap compared with their earnings and earnings growth potential. I have portentously titled the ratio used by the screen the 'genuine value' (GV) ratio, but effectively it is a price/earnings growth (PEG) adjusted for dividend and the net debt/cash held by a company.  This valuation favours companies that have healthy net debt/cash positions. That given, it is worth always bearing in mind that companies that display such characteristics often do so to counterbalance other types of business risk. The write up of T Clarke below (a cyclical business with a pension deficit and large working capital items) provides an example of why sensible management teams would want to ensure a company and shareholders have the benefit of such a buffer.

The screen assesses all companies in the FTSE Aim All-Share and FTSE All Small indices using the following screening criteria:

• A genuine value (GV) ratio among the cheapest quarter of companies screened.

GV = (enterprise value (EV)/operating profits (EBIT)) / (average forecast EPS growth for the next two financial years / historic dividend yield (DY))

• Better than median average three-month share price momentum
• Forecast growth of less than 100 per cent in each of the next two financial years (ie, not ridiculously excessive)
• Forecast EPS growth rate must not for by more than half from one financial year to the next
• NEW TEST: An upgrade to next-12-month consensus EPS forecasts during the past quarter or no downgrades in the past quarter and an upgrade in the past year.

I’ve provided two tables. The first details the shares that pass the screens tests based on the new criteria with the second showing the additional stocks that met the screen’s criteria except the new earnings-revision test. Both tables are ordered from lowest to highest GV ratio. I’ve also taken a bit of a closer look at two of the stocks selected by the revamped screen based on the 'cheapest' and most 'expensive' stocks based on GV ratio (all stocks are among the cheapest quarter of those screened based on GV).

Genuine value small-caps 2.0

Source: S&P CapitalIQ

Source: S&P Capital IQ

T Clarke

Investors are never likely to want to pay up for a low-margin, cyclical company, that has to manage the risk associated with carrying large (relative to profits) working capital items. That considered, it should not come as too much of a surprise that shares in fit-out group T Clarke (CTO) look very cheap.

However, for bolder investors, it would arguably be wrong to dismiss the shares simply due to some of the key characteristics of businesses in T Clarke’s sub-sector. Indeed, offsetting some of the justified concerns investors may have, T Clarke looks a tightly-managed operation with a relatively robust balance sheet and market-leading positions in a number of strategically-interesting areas. What’s more, despite management’s assertion that a strict price discipline is maintained when bidding for work, business is currently booming. The order book jumped from a record £337m at the end of last year to £368m at the end of April. That means all of T Clarke’s expected £300m of sales are secured for the current year, along with a further £147m for the following year, and £40m beyond that.

Given the low-margin nature of fit-out work and the scope for intense price competition between companies, it is encouraging that T Clarke has been investing in specialisms that allow it to take on complex jobs where skills rather than price are a bigger determinant of successful bids. What’s more, with increased requirements for digitisation, 'intelligent building' design, and growing environmental regulation, fit-out work is only likely to become more specialised. As part of T Clarke’s ongoing efforts to capitalise on the opportunities these trends are expected to bring, it paid an initial £1.5m to acquire digital specialist Eton Associates last year. It also invested £1m to increase prefabrication capacity. 

In a sign of its confidence in being able to win work on attractive terms, in March T Clarke set a medium-term target of achieving a 3 per cent operating margin compared with the current level of 2.7 per cent. This should be helped by action taken last year to address problems at the group’s Central and South West division, which slipped into the red, making a £1.8m underlying loss compared with a £900,000 profit the previous year.

Despite last year’s spending on the Eton acquisition and investment in new capacity, tight management of contracts helped the company increase net cash from £9.8m to £11.7m in 2017. And despite a step-up in pension top-up payments this year from £1m to £1.25m (to be followed with annual payments of £1.5m thereafter), broker N+1 Singer expects the group to end 2018 with net cash of £13m.

The cash needs to be seen in the context of a £23.4m pension deficit and the large amounts of money that T Clarke typically has owed to it by customers and others (£93.7m at the end of 2017) and it owes to suppliers (£98.5m). Having such large items on the balance sheet is to be expected, but also represents a noteworthy risk given the low-margin and cyclical nature of the sub-sector.

But trading is strong and, for this space, the company looks a well-positioned, quality operation. If the business continues to perform well, there should be scope for the rating to get more generous than the current level. The dividend yield is attractive, too.

Forterra

Recently there have been signs that housebuilders – particularly Crest Nicholson – are feeling the strain of rising costs. Arguably, this highlights the attraction of taking a more picks-and-shovels approach to the UK-housing-shortage theme. From this perspective, as the UK’s second-largest brick maker and selling almost two-thirds of its product to the new-build housing industry, Forterra (FORT) looks of interest.

With planning permission for new brick-making sites very hard to achieve, UK brick manufacturers enjoy high barriers to entry. Strict planning rules also restrict expansion by incumbents and concentrated ownership is also conducive to a controlled approach to supply growth. Indeed, according to the estimates of broker Berenberg, 90 per cent of the market is divided up between just three players and the industry is running at near-full (95 per cent) capacity. The broker also points out that imports are normally more expensive than domestically produced bricks after accounting for shipping costs, and sterling’s post-Brexit weakness has made them less competitive still.

Demand is also strong and is expected to increase in coming years. With government providing incentives aimed at boosting new-build demand and supply, housing starts are increasing but remain only around half the target of 300,000. This combination of solid demand and a tight brick supply makes for a high returns. In fact, Berenberg forecasts Forterra will achieve operating profit margins of about 19 per cent in coming years.

Against such a favourable backdrop, Forterra is looking to use its robust balance sheet to increase capacity. Last September it acquired a company called Bison for £20m which has made it the market leader in precast concrete. It also plans to invest £90m-£95m to expand its site in Desford, Leicestershire, which would increase its brick-making capacity by about 16 per cent. The internal rate of return on the investment is estimated at an attractive 15 per cent after tax over a 20-year life for the expanded plant. However, the spending is not expected to have a marked effect on profit until 2022 when the plant should be properly up and running.

Despite the five-year wait for the new plant, decent growth is forecast in the meantime and the strong underlying market conditions provide grounds for confidence in the numbers and the potential for forecast to keep nudging higher.