12 cheap small-cap growth stocks

Shares in listed smaller companies are often regarded as something of a barometer for sentiment towards the domestic economy because sales tend to be UK focused. This means many small-caps have been at the sharp end of ongoing Brexit angst. For investors willing to back the prospects of the UK economy, though, this means they should currently present an opportunity.

The genuine value screen tries to find undervalued growth plays. The risk of this approach, as with any approach focused on value, is that the shares highlighted will be in companies that face problems that are not immediately evident from the screening criteria. The mixed performance of the stocks chosen last year demonstrates the risk of this screen highlighting shares that are cheap for a reason.

2018 performance

Source: Thomson Datastream

Overall, the screen has had a pretty good run since I began following it in mid-2013. The cumulative total return over the six years has been 106 per cent, compared with 55 per cent from the market, based on a 50:50 split between the FTSE Aim All-Share and FTSE Small Cap indices (the indices the screen selects shares from). This 'headline' performance figure doesn’t tell the whole story, though, because small-cap shares can be very expensive to trade due to wide bid-offer spreads, as well as other dealing costs. The screens run by this column are regarded as sources of ideas for further research rather than off-the-shelf portfolios, but if I add in a 2.5 per cent annual charge to inject a dose of reality into the performance figures, the six-year total return drops to 76.9 per cent, which is still some way ahead of the index.

The full criteria for this screen are:

• A genuine value (GV) ratio among the cheapest quarter of companies screened. This is like a classic price/earnings growth (PEG) ratio adjusted for a company’s net debt or cash and dividends.

          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 high).

• Forecast EPS growth rate must not have more than halved from one financial year to the next.

• EPS forecasts must have either been upgraded during the past quarter or at least not downgraded in the past quarter and had an upgrade in the past year. EPS forecasts are based on predictions for the next 12 months (NTM).

This year 12 stocks passed all the screen's tests. I’ve taken a closer look at two of the shares highlighted below.

Source: S&P Capital IQ

Speedy Hire

Equipment hire companies are cyclical and their operations are heavily dependent on assets (the equipment they hire out), which means a large fixed cost base that causes profits to be very sensitive to changes in sales when demand takes a cyclical upturn or downturn. So valuations of shares in this sector are highly dependent on expected returns on invested capital.

On this basis, Speedy Hire (SDY) offers investors a good-news-bad-news story. The good news is that management initiatives are raising returns on capital. The bad news is this hard work could be undone by an economic downturn, and Brexit, combined with trouble in the construction sector, are providing cause for concern.

Taking the good news first, management is optimising the equipment held, improving fleet management, pushing into the small- and medium-sized enterprise (SME) market, and improving customer service. Investment in technology has been a big help. Machine learning is helping boost utilisation rates (the amount of time equipment spends out on hire), a new app is bringing in business, and the company has been able to introduce same-day delivery (four hours in London) on its 56 most popular bits of rental equipment.

Results for the year to the end of March provided solid evidence of progress. In the UK, where Speedy is the leading tool hire company, utilisation, which is a key determinant of returns, rose from 55.4 per cent to 57 per cent. What’s more, there could be the potential for hire rates to start improving in the UK following a dull period. “Industry utilisation may have got to the level where pricing can improve,” says Peel Hunt analyst Andrew Nussey. “That’s important in an industry where for every extra pound in pricing, 90p falls through to profit.”

Meanwhile, improved customer service has seen SME customers flock to Speedy, with revenue from this market up by a quarter last year and accounting for nearly a fifth of UK sales. This was enough to offset the £8m hit from the collapse of Carillion with overall like-for-like sales 0.4 per cent ahead. The company’s international business, which is focused on the Middle East’s oil and gas industry, also put in a strong performance. News on a major international contract renewal is due in August.

There’s certainly scope for further improvement and in some markets Speedy could benefit from the balance sheet strain being experienced by rival HSS Hire. Improved performance of the powered access business could be another plus. The company has also invested heavily to get into this market (£52m since November 2017) but has been disappointed in progress so far. But it is hoped the acquisition of Lifterz in March for £21.5m (£9.6m cash paid and £11.9m debt acquired) could kick-start performance as the deal gives the operation full international coverage.

The group also bought a training business last year and spent £30.9m in total on deals. Increasing revenues from capital-light services is seen as a means to increase returns on capital while exploiting the increased regulatory requirements in the construction industry. With net debt of 1.1 times cash profits (Ebitda) well inside the target level of 1.5, the company has the financial scope for more acquisitions while continuing to invest in fleet.

Peel Hunt sees the potential for Speedy to increase return on capital invested from about 10 per cent towards the 15.5 per cent being achieved by rival Ashtead and reckons this could prompt Speedy’s enterprise value (EV) to forecast cash profit (Ebitda) rating to rise from 4.8 times to closer to Ashtead’s 5.9 times. That said, the more attractive structural and cyclical growth trends enjoyed by Ashtead’s US-focused business means Speedy may struggle to justify a rating in line with its peer. All the same, Speedy’s shares do not look expensive and management's strategy is lifting returns and, in turn, revving up profit growth.

The catch is that all this is happening in the shadow of considerable economic uncertainty. As well as Brexit, there are troubles in the construction sector illustrated most recently by Kier’s drastic restructuring moves and illustrated most totemically by the collapse of Carillion last year. Doubts are creeping in about the future health of the housebuilding sector, too, with criticism mounting over both build quality and long-running Help to Buy government incentives, but private rental builds and affordable homes may pick up any slack. Company-specific issues aside, the consensus is that the outlook for UK construction activity overall is stable.

There are a number of things to like about Speedy’s direction of travel, the balance sheet is reassuring and the shares look decent value. The caveat is that the shares represent a 'late-cycle' bet on a cyclical business at a time when the economic outlook is fraught with uncertainty.

Belvoir Lettings

Estate agent Belvoir Lettings (BLV) is a business that is arguably more defensive than it first appears. For traditional estate agency players, housing market transactions are slowing and falling revenues combined with high fixed costs are causing pain.

But Belvoir can genuinely claim to be different. It operates a capital-light franchise model, whereby it provides central services for 365 franchisee offices in exchange for a fee linked to office revenues. Of its total income, 71 per cent comes from letting, which provides far more stable revenue than lumpy and cyclical transaction revenue.

Only 18 per cent of fees come from transactions and the rest is from Belvoir’s fast-growing financial services operation. Financial services was bolstered by two acquisitions last year. Meanwhile, the group has limited exposure to the struggling London market with fees from the city accounting for only 7 per cent of the total last year.

The lettings market is not without challenges. Agents are having to deal with a rising tide of regulation, including a tenant-fee ban and rising tax burdens for landlords. But Belvoir has sought to get ahead of the curve. Its preemptive compliance with regulation is improving the competitive advantage of its franchisees and helping them win market share. The company is also helping franchisees grow by offering loans to finance the acquisition of rivals, some of which may be struggling to comply with new regulations. Importantly, the franchise model means the more the network grows, the more profitable the franchise owner – Belvoir – should become as franchisees lay out most of the costs associated with new office openings.

Belvoir recently reported strong first-quarter trading with a 6.3 per cent rise in managed service fees for lettings, which was well ahead of the market based on a 1.2 per cent increase in the rental index. The shares offer an attractive dividend yield and look much less risky than those of traditional estate agents as long as the company can continue to skilfully navigate rising regulation.