Slater Screen takes Aim

2017 PERFORMANCE

Source: Thomson Datastream

Over the five years I have run the screen, its cumulative total return now stands at 188 per cent compared with 75 per cent from a combination of the Aim and Small Cap indices. Small-caps can often be very expensive to deal due to wide bid/offer spreads, so if I inject a bit of reality into the performance figures by factoring in a notional 2.5 per cent annual charge, the total return drops to 154 per cent (the screens are run on the assumption that for most readers they are of interest as a source of ideas rather than an off-the-shelf portfolio).

A key aspect of the Slater screen is to look for small companies where growth prospects are undervalued. To do this, Mr Slater recommended using a price/earnings growth (PEG) ratio, which is a rough-and-ready way to look at the price investors are being asked to pay for a stock relative to earnings (the price/earnings ratio) compared with earnings-growth potential. To put it in a formula:

PEG = PE/EPS growth

The PEG used by this screen looks at price to last year’s earnings compared with the average forecast growth for the next two financial years. The PEG ratio tends to be at its most useful when it is not the product of extreme data (ie, a suspiciously low PE or an unsustainable growth rate). The other criteria used by the screen help test whether the message given by the PEG is likely to be valid. Mr Slater’s must-read Zulu Principle book also recommended a number of “qualitative” techniques investors can employ to check whether a company’s prospects are likely to hold up. This screen uses forecast upgrades and share price momentum as a kind of short-hand, 'quantitative' way to achieve this goal. The full criteria are:

■ A PEG ratio (PE divided by average forecast earnings growth for the next two financial years) in the bottom quarter of all stocks screened. It's worth bearing in mind that small-cap earnings forecasts are often not of the highest quality (nb: FTSE All-Share, All Small and Aim have been screened separately).

■ Market cap of less than £750m but more than £10m.

■ Net-debt-to-cash-profits ratio of less than 1.5.

■ Cash conversion of 90 per cent or more.

■ Return on equity of more than 12.5 per cent or an operating margin of 15 per cent or over.

■ Three-month momentum higher than the median average, or forecast EPS upgrades of 10 per cent or more over the past year.

■ Forecast earnings growth in each of the next two financial years and average forecast growth of more than 10 per cent but less than 50 per cent (anything above 50 per cent is considered an unsustainable growth rate for the purposes of this screen).

This year, seven of the nine shares passing all the screen’s tests heralded from the Aim market. These stocks, along with certain key fundamentals, are listed in the table below. I’ve also taken a closer look at two of the shares based on strong three-month share price momentum (Impax) and three-month forecast upgrades (Dewhurst).

2018 Zulu shares

Source: Thomson Datastream

Impax Asset Management

When Impax (IPX) was flagged up by this screen a year ago, the specialist fund management group had established a trend of earnings upgrades on the back of strong net inflows into its funds. The trend has continued and the company now boasts 11 back-to-back quarters of net inflows.

Impax is benefiting from increased interest in the theme of sustainable investment, which is its forte. Appetite for this type of investment is underpinned by a range of regulatory, demographic and social factors, from legislation to get more electric vehicles on the road, to an increased focus on healthy living by consumers.

Impax has been making the most of this favourable backdrop by improving its distribution, including distribution through third parties, and broadening the products it offers. The recent acquisition of US-based Pax Management has helped this process by introducing new product areas, such as fixed income and smart beta, as well as giving the traditionally institution-focused group more exposure to private investors. Possibly the best way to illustrate the group’s phenomenal growth is simply by extending the chart used in this column a year ago to take account of recent quarterly inflows (see below).

Despite a 114 per cent total return since the shares were highlighted last year, the extent of the EPS growth achieved by Impax and forecast by brokers means the PEG ratio remains unchanged on a year ago at 0.7 times despite the mighty share price ascent. That said, broker Peel Hunt puts the group’s cash-adjusted price/earnings ratio at the top end of the wider sector.

While the above chart does show some slowing in quarterly inflow, the attraction of Impax’s investment specialism and reported level of interest in its products remain high so the broad trend seems likely to continue. That means there could be more broker-forecast upgrades to come, which one would expect to continue to push the shares higher, especially as the valuation does not seem too stretched despite stellar gains last year.

Dewhurst

It’s easy to overlook the attractions of a company when it is small and operations are as dull as manufacturing controls and electrical equipment for the lift, keypad and transport industry. Aim minnow Dewhurst (DWHT) does boast such snore-worthy credentials but it also ticks several boxes as an investment.

The company operates in a niche market, which should help it hold its competitive edge despite its diminutive size. And while cyclical, its operations are diversified based both on the markets its serves and also its international reach. Another point in Dewhurst’s favour, although arguably a more contentious one, is that the Dewhurst family owns over half the shares with voting rights (A shares have no voting rights) and family members hold several key management positions; several studies have found listed 'family' businesses produce higher shareholder returns in the long term than peers, which is possibly due to the longer term and more prudent thinking encouraged by family involvement.

Encouragingly, these points appear to be reflected in the returns on capital and margins that Dewhurst boasts. That said, the cyclical nature of the business, along with write-downs, can be seen in the 2012 and 2013 performance blip in the chart below.

Things could be about to step up a gear for the manufacturer. Having built up an £18m net-cash pile (separate to an £11.7m pension deficit), the company has recently found a way to put a big chunk of that money to work with the acquisition of a major distributor to the UK lift industry, A&A Electrical Distributors. Dewhurst should have good knowledge of A&A as A&A has been a major distributor of its products for many years. What’s more, the couple that founded and ran A&A for the last 35 years will now become non-executive directors of Dewhurst, both drawing a £20,000 salary.

Excluding the founder’s salaries, A&A made a hearty £3.3m pre-tax profit last year on £11.4m of sales. Dewhurst is to pay just £10.5m for this business along with a quarter of its profits over the next two years, suggesting the acquisition should make a substantially better return for the company than holding cash in the bank. Indeed, the deal triggered substantial upgrades and underpins forecasts by house broker Cantor Fitzgerald that EPS will jump from an expected 57.8p this financial year to 75.9p next.

However, while the acquisition bump does mean Dewhurst has appeared as the top stock on our list for three-month earnings forecast changes, the outlook is not entirely positive – as suggested by the negative share price movement over the last three months. Indeed, the most recent forecast change made by Cantor has been a downward revision to numbers.

A key issue for Dewhurst in the first half of its financial year was the negative impact on reported numbers of sterling strength. Sterling has since weakened. Meanwhile, the disposal of a door business and restructuring of a US operation both weighed on first-half revenue. And while conditions are broadly positive in end markets, the UK (one-third of sales) is being affected by Brexit uncertainty and keypad orders are judged by management to be in a period of long-term decline.

The shares’ valuation does seem to take some account of these negative factors, though. There’s also an attractive dividend and a solid record of dividend growth. It is a shame about the wide bid/offer spread, though.