Seven high quality small caps

2017 performance

The cumulative total return from the screen over six years stands at 184 per cent, or 151 per cent after factoring a 2 per cent annual charge to attempt to account for the high dealing costs associated with small cap investing. That compares with a 96 per cent total return over the same period from a 50:50 combination of the FTSE Small Cap and FTSE Aim indices.

Given that an objective for most investors hunting for quality shares is to find long-term investments, the buy-and-hold performance of this screen is of some interest. One noteworthy feature of the table below is that the two portfolios selected by this screen over the last six years which underperformed the market in their first 12 months have gone on to significantly extend that underperformance when looked at on a buy-and-hold basis.

Buy and hold performance

The screen looks at a number of classic measures of quality. The measure of valuation it uses is a souped-up version of a price/earnings growth (PEG) ratio. A standard PEG ratio compares the price being paid for a share as a multiple of earnings per share (EPS) with earnings growth. The ratio used for this screen, which I rather portentously call a genuine value (GV) ratio, factors dividend yield and the amount of debt and cash on a company’s balance sheet into the PEG ratio. The GV ratio formula is:

Enterprise value to operating profit (EV/EBIT) / expected EPS growth rate plus dividend yield (Fwd EPS grth + DY)

Enterprise value is a company’s market capitalisation plus its net debt. A key reason for using it is to get a better idea of a ‘whole company’ valuation by including the value finance provided by lenders as well that from equity holders (market cap).

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

• 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 past 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.

This year seven companies passed all the screen’s tests and six of them came from Aim. These stocks along with some key fundamentals can be found in the table. The table is ordered from lowest (cheapest) to highest GV ratio.

Seven high-quality small caps

Source: S&P Capital IQ

Lowest GV: Swallowfield

Beauty products group Swallowfield (SWL) is attempting to move up the beauty-industry value chain by investing in brands. The hope is this will boost the returns it generates from its know-how in product innovation and manufacturing.

Such strategies do not always progress smoothly, and for Swallowfield, the financial year to the end of June has been a case in point. The share price performance and valuation seem to reflect recent mixed fortunes. However, where it really matters (brands), the recent progress made by the company has been encouraging. Meanwhile, the problems faced by the group’s manufacturing business that have been the source of recent woe, may soon abate.They also explain why the company is looking to take more control over its own destiny through the ownership of brands as opposed to its traditional role of supplying owners of top brands.

The financial year before last saw a rash of product launches by key customers, which resulted in bumper trading for the manufacturing division and the 12 months to mid-2018 was always going to pale in comparison. This issue was compounded by two other disappointments that surfaced at the manufacturing business during the second half: the commencement of three major contracts was delayed, and the company was unable to adjust for a sharp increase in raw-material prices quickly enough to protect margins. To add to investor concerns, a jump in working capital will result in a sharp increase in net debt to £11m at the year end; the size of the rise in debt being the cause for concern rather than the actual debt level which represents 1.7 times forecast cash profits. The company also has a £5.7m pension deficit.

The good news is that the delayed contracts are expected to be up and running soon and management has a plan in place to revive margins. Meanwhile, following the year end, working capital is expected to quickly get back down to more normal levels bringing net debt down sharply. Nevertheless, the negative developments, which were revealed in a year-end trading update last month, were enough to make house broker N+1 downgrade cash profit forecasts for the manufacturing division by £1.7m. Given that group cash profit in 2017 was £5.2m, the magnitude of the setback may have been expected to have very painful ramifications for overall profit forecast. However, this was not the case thanks to the much-better-than-expected progress made by Swallowfield’s brands. Indeed, the overall impact on N+1 Singer’s 2018 and 2019 EPS forecasts were downgrades of just 4 per cent and 5 per cent respectively.

Swallowfield’s real potential as a ‘quality’ play lies in the opportunity to grow the higher-margin brands business. Brands accounted for 31 per cent of first-half sales and 57 per cent of first-half profit, and in the 2017 financial year the division’s operating margin before central costs of 16 per cent was almost double that of the manufacturing business. A strong brand gives its owner increased pricing power allowing it to grow and protect its margins. A strong brand also means more reliable sales growth. These factors translate into what investors refer to as high ‘earnings quality’. This dynamic is reflected in the rise in margins over recent years and forecasts of more of the same (see graph).

So arguably the more significant news from last month’s trading update was not the manufacturing disappointment but that brand revenue increased by 16 per cent in the 12 months and that the division’s profitability “will be significantly above both management’s expectations and the prior year as a result of improving margins”.

Brand margins are being enhanced by the company bringing the manufacture of recently acquired brands in-house. The most recent brand acquisition was the £3m purchase of men’s hair styling brand ‘Fish’, which will hopefully build on the strong growth Swallowfield has enjoyed from the product category. Meanwhile, the company has been investing in its manufacturing facilities to boost efficiency and is also expanding into international markets. Overseas sales made up 24 per cent of brand sales last year, although challenging conditions in North America have been a drag.

The appointment of Tim Perman as chief executive following a succession period of several months should also keep the group’s focus firmly on brand growth given his previous job as PZ Cussons' group brand director and divisional global beauty director.

If, as management expects, the manufacturing business is poised to get back into its stride and net debt moves downwards quickly, investors may start to focus more on the potential for the brands division. There could even be positive news on these fronts in the company’s full-year results announcement scheduled for 25 September. The existing sales growth and margin trends suggest scope for a noteworthy re-rating of the shares should the strategic shift be a success.

Highest GV: IG Design

The experience of IG Design (IGR) over the last several years can in many ways be seen as a blueprint for the kind of strategy Swallowfield is looking to implement. In IG’s case, the re-rating of its shares was helped by the fact that high borrowings gave it the opportunity to use its cash generation to pay-down debt and transfer value from its lender to its shareholders. And while the group’s business of supplying gift wrap and associated knick-knacks may not be too glamorous, the company certainly displays some key characteristics of a quality play. That said, the quality credentials may be given short shrift by those who remember the torments wrought on IG and its shareholders by the last recession, which struck after debt had been piled high to fund an aggressive, and rather over ambitious, acquisition strategy.

A key ingredient in the success IG’s management has had reviving the company’s fortunes has been its ability to grow margin.

While the gift wrap industry may sound highly competitive, IG’s recent experience suggests scale provides quite an effective barrier to entry. As a top-three player in the industry, IG is one of the few companies capable of supplying large national and international customers. It has built a balance sheet able to cope with huge seasonal fluctuation in working capital, especially around Christmas. It also has control of its entire supply chain, helping to insulate itself and its clients from external surprises. Meanwhile strong cash generation means it has been able to invest in IT and production to keep it ahead of rivals and make bolt-on acquisitions to take it into new product categories and geographies. All of this has resulted in strong share price momentum supported by EPS forecast upgrade (see graph).

However, this very impressive performance has not gone unnoticed by investors. Priced at 21 times forecast next-12-month earnings, the shares can hardly be described as cheap. What’s more, the key valuation metric used by this screen (the genuine value ratio) flatters IG by taking account of year-end net cash and ignoring seasonal swings which meant the group actually had average net debt last year of £42m (this represented 1.5 times cash profits which is the very bottom of the group’s target range.)

Over five years IG’s enterprise value/forecast cash profit (EV/fwdEBITDA) rating has multiplied by just over 2.5 times, while debt reduction has magnified the re-rating impact on the price/next-12-month forecast earnings (Fwd NTM PE) ratio – it has experienced a mammoth four-fold rise.

With return on average net capital employed sitting at 22 per cent, a robust balance sheet, strong cash generation and excellent track record over recent years, the shares certainly look ‘quality’. But given so much margin improvement is already in the bag, the question for investors is whether IG’s prospect justify such a heady rating or are we looking at an as-good-as-it-gets valuation?

Based on the company’s targets, the game is not yet up. The plan is to push operating margins from the 7 per cent achieved last year to 8 per cent, which is something that broker Berenberg believes will be exceeded in 2020 when it predicts an 8.2 per cent margin. The broker forecasts 7.6 per cent in the current year. Meanwhile, the company aims to deliver sustained double digit growth in earnings.

The company should be helped achieve its goals by product innovation and cross selling to existing clients looking to consolidate supply. International expansion, the group’s tight focus on costs, rising sales of higher margin products and acquisitions should also all help. Plans to reduce the reliance on Christmas sales by focusing on events such as Halloween and Valentines Day may also help increase perceptions about the quality of the company’s earnings. All in all, IG has a lot going for it and has set out clear plans to make the business ever more desirable to investors. But the shares aren’t cheap, especially given the cyclical nature of its markets. The company may need to keep up its track record of beating broker expectations for the rating to hold firm and for share-price momentum to continue.