Ten cheap small-caps

There is a logic to the gung-ho strategy of buying shares in troubled companies when markets have tanked (for many, though, the uber-high risk is simply unpalatable). The most heavily sold off shares are likely to be those that are most vulnerable to the adverse conditions that have caused the market to fall. Any improvement in sentiment about those conditions is therefore likely to disproportionately favour such stocks. 

We’ve already seen some evidence of this strategy working during the past few months, with shares in some heavily indebted and hard-hit companies soaring by quite astonishing amounts in percentage terms during the mid-March market rebound.

There is a very good reason many investors do not pursue the 'dash for trash' strategy during times of uncertainty and panic. The stocks that benefit most from a market upswing are also those that are most likely to experience a permanent loss of value or even total wipeout if problems persist. Indeed, most of the shares that rallied hardest in March remain well off pre-crisis levels. Given it is notoriously difficult to distinguish a genuine recovery from a bear market rally, the strategy is very high risk. 

Risk warnings aside, this week’s screen uses the methods of famed contrarian David Dreman in order to try to identify cheap small-caps. This is a fertile hunting ground for anyone looking for vulnerable shares that could swing wildly on changing sentiment. 

The screen uses several valuation metrics to try to identify 'cheapness'. Normally when I run this screen I include shares that are 'cheap' based on a version of the price/earnings growth (PEG) ratio. This ratio is based on forecast earnings growth. The coronavirus shock has temporarily made forecasts next to useless as analysts scramble to update models while faced with a situation that is very unpredictable. I’m therefore ignoring stocks that look cheap based on PEG this year as the valuation is likely to prove highly misleading. 

True, a similar argument could be made about all the other valuation metrics used by this screen. The dividend yield especially is questionable given it is usually taken to indicate a tangible payout, yet many dividends have been cut severely and may take time to resurface. But the other ratios used by the screen do at least provide an indicator of potential based on the past – something companies may regain in time. Near-term growth expectations, however, are pretty much redundant.

Mr Dreman was actually not an advocate of small-caps, but the screen can identify some interesting situations as a basis for further research. The screen’s full criteria are as follows:

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) or price-to-book-value (PBV). Shares that appear cheap on one or more of these valuation measures must also pass the following tests:

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

■ Forecast EPS growth in each of the next two financial years (this test should be taken with a big pinch of salt at the moment and passing it may have more to do with thin broker coverage than actual growth potential). 

■ 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. 

■ 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.

While many 'cheap' stocks have taken a pounding during the recent market sell-off due to their perceived vulnerabilities, the 13 picks from last year's screens have actually fared pretty well considering (see table). I am currently unable to access my usual source of total return data due to the coronavirus lockdown, so cannot provide long-term performance numbers for the screen. I will update all performance data once back in the office and will include it in my normal end-of-year review – assuming it is business as usual at that time.

Last year's performance

Source: S&P CapitalIQ

Ten shares passed this year’s screen and are listed in the table below. I’ve also taken a closer look at two of them. Finsbury Food looks the best of the two to me, although as one would expect, there’s still plenty not to like.

10 cheap small-caps

source: S&P CapitalIQ

Finsbury Food

Finsbury Food (FIF) is one of the UK’s largest bakers and makes a range of breads and cakes. It has its own brands, such as Memory Lane cakes, it pays to license brands, such as Vogel, Thorntons and Disney, and it makes own-label products for supermarkets.

Finsbury’s core business has stood up relatively well to the coronavirus shock, with strong demand for bread offsetting weaker demand for cakes. However, the fifth of revenue that comes from its food services business has seen a substantial drop-off in demand as its customers, such as pubs, hotels and fast-food chains, have shut. The company has temporarily closed one of its seven UK sites in response and is also cutting back on non-discretionary spending across the group. 

Aside from the immediate Covid-19 concerns, over recent years the key issue for investors in Finsbury has revolved around its limited pricing power, high fixed costs and relatively high capital requirements due to the investment needed by its bakeries. The relatively weak position it has with powerful customers, such as big supermarkets, has been particularly apparent because Finsbury has faced cost increases on several fronts – labour, ingredients and utility bills. Meanwhile, the rise of discounters has increased the determination of supermarkets to negotiate hard with suppliers.

In response to the tough conditions, the company has invested heavily in its factories to increase efficiency and cut costs through reorganisation. So far this has proved a case of running hard to not quite stand still, with adjusted operating margins edging downwards over recent years. Meanwhile, debt taken on to fund the acquisition of a 'free from' baker last year has caused interest costs to rise. This is hardly inspiring, especially with the pain being doled out on the food services business.

That said, cash generation has recently benefited from the end of three years of increased investment in the company's operations. This was reflected in a £3.5m drop in net debt in 2019 to £32.6m (unlike our table, these figures do not include lease liabilities). Finsbury should also benefit from the investments made in previous years. 

Despite the recent fall in debt, borrowings do remain high by historical standards as a result of last year’s acquisitions. However, comfort can be taken from the headroom the company has from its debt facility of £55m, along with an additional accordion facility of £35m, both of which are available until February 2023. Debt of £44.5m was drawn at the half-year stage. A noteworthy balance sheet feature is a defined-benefit pension scheme that is £11.3m in deficit. As a general point, falling interest rates and falling equity prices have the potential to see pension deficits blow out.

Covid 19 aside, Finsbury’s shares have tended to be cheap for a reason, but they are potentially very cheap should the business rebound. The company does not look very high quality given it is stuck between powerful customers and many uncontrollable costs. Management also has an unfortunate habit of cherry-picking 'headline' numbers by seeming to switch between presenting adjusted and statutory versions of its earnings, depending on which casts the business in the best light. However, the prospect of improving cash generation and some potential benefit from the investments made over recent years provide some reasons to be positive. The defensive core business is also a plus, as is the extra debt available should need be. So, while there are risks and the company is never likely to boast stunning profitability, based on both sales and book value the shares look undeniably cheap.

Springfield

Scottish housebuilder Springfield (SPR) has been one of the sector’s 'value' plays for some time. There are things to like about the company, but the low rating compared with peers also reflects company-specific risks and business performance. I’ll start with the positives.

With the UK and the world on the brink of entering a major (and let’s hope brief) recession, one of the things going for Springfield is its affordable housing business. These operations should prove relatively defensive. Last year, 23 per cent of sales came from this division. These operations are certainly not bulletproof and could get into trouble if its housing association clients encounter financial difficulty. However, it is definitely a reassuring place to be at the moment.

The company is also making inroads into the private rented sector through a recent agreement with specialist developer Sigma Capital. The high demand for this type of property and burgeoning investor interest could provide a buffer against troubles in the wider housing market. 

And the private homes division, which accounted for three-quarters of sales last year, could also benefit from the affordability of housing in Scotland relative to similar properties in England. Scottish house prices held up relatively well during the credit crunch, although volumes tanked and were still about 30 per cent from their peak in the 2017-18 tax year according to Registers of Scotland. 

However, there are clear risks with the company too. The private housing market is cyclical and must be expected to suffer as a result of the oncoming recession, possibly very badly. Springfield’s exposure to private homes has been increased over the past two years through the acquisitions of Walker Group just over a year ago and Dawn Homes in May 2018 – part-funded through a £15m placing at 120p.  

These two acquisitions have helped Springfield lift its overall gross margin, which rose from 17.2 per cent to 19.9 per cent during the first half of the financial year. All the same, it goes into the downturn as one of the least profitable UK-listed housebuilders. That’s not a good place to be at a time when house prices could come under severe pressure.

Any problems Springfield does encounter are likely to be compounded by its balance sheet. Housebuilders are renowned for having to carry a lot of risk on their balance sheets. That is certainly the case with Springfield. 

A key area of balance sheet risk for housebuilders is the land they own to build on in the future. When house prices fall, the value of land really takes the strain because the other costs involved with building a house – bricks, labour etc – are far less flexible. 

Given the current backdrop, it is therefore a worry that Springfield owns a lot of land – enough to last it over 16 years at current build rates. The company’s work in progress and inventories (most of which represents land) was valued at £171m at the half-year stage. This leaves scope for substantial writedowns that could seriously damage book value – the measure of value that housebuilders are most usually valued against.

The other big balance sheet risk that housebuilders can display is the level of debt taken on to fund their large working capital commitments. On the whole, housebuilders have been relatively conservative about borrowing during this cycle. However, compared with peers, Springfield has a lot of debt relative to its size. At the last count, net debt stood at £56m, which compares with banking facilities of £67m. The balance sheet also carries deferred considerations of £11.5m for the Dawn and Walker acquisitions, although much of this is linked to planning submissions and approvals. 

Given the balance sheet and the cyclical risk, it’s not surprising that the company has decided to pull a previously announced first-half dividend of 1.4p. Still, this looks a risky play to my mind given there is the potential for the apparent value picked up by the screen to evaporate if we get a serious housing downturn.