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12 cheap small-cap growth plays

The coronavirus crash makes it a peculiar time for my Genuine Value small-cap screen
July 7, 2020

When it comes to valuing companies, there is no definitive method that should be used. There are many different valuation tools and investors need to pick the right one for the job at hand. This consideration seems particularly relevant for this week's screen, as the impact of coronavirus makes the valuation tool it focuses on quite an odd one to be using to screen for shares. 

Click here for our 3-step guide to valuation

The valuation ratio in question is a slightly amended version of a classic price/earnings growth (PEG) ratio. This ratio attempts to look at how much investors are being asked to pay for shares in a company based on its earnings, which is then put in the context of expected earnings growth. It attempts to identify growth on the cheap. The actual maths simply involves dividing the price/earnings ratio (PE) by expected earnings growth (Fwd EPS grth). For those who like formulas, it can be written like this:

PEG = PE / Fwd EPS growth

The issue for investors using a PEG ratio is that it is often a case of garbage-in, garbage-out. One of the ratio’s biggest proponents is top performing fund manager Mark Slater, who is the son of the man who did so much to popularise PEG in the UK in his excellent book The Zulu Principle, Jim Slater. Mr Slater junior tends to view a low PEG as a less useful indicator of value for stocks when PEs and growth rates are either very high or very low. 

As a rough rule of thumb, investors can think of the PEG sweet spot occurring when its inputs are between 10 and 25 on either side of the equation. The ratio is also often considered to indicate value when it is below one.

There’s a very good reason for taking this stance. When PEs are very low or very high they are generally not giving investors terribly useful information. A low PE is a suggestion that the market does not have faith in the earnings part of the ratio, while a very high PE suggests investors do not believe recent or forecast earnings are anywhere near representative of the long-term potential. 

Given the incredible drop in earnings that coronavirus will cause for many companies, their shares are likely to be flashing signs of amazing value based on low PEs. But for many the low PE will actually be flashing a sign of a business in amazing trouble. Meanwhile, forecasts of stunning earnings growth in coming years may well only be a reflection of a recovery following a period of utter profit decimation that does not even get profits close to former peaks – a 90 per cent drop in earnings, for example, requires a 1,000 per cent recovery to reclaim past highs.

So, what’s a stock screen to do? Fortunately my genuine value screen does already try to take some account of these issues by limiting the growth rates it accepts as inputs. However, these tests are extremely loose – almost laughably so. Indeed, the screen was intended as a bit of a purist test of the PEG-style ratio at its centre. Given the original intent, my inclination is not to tinker with the criteria but to just say this screen’s results come with a health warning at the current time. After all, the screens run in the column are always meant as a source of ideas for further research and not as ends in themselves. The screening criteria are:

  • A genuine value (GV) ratio among the cheapest quarter of companies screened. This is the ratio the screen uses, which is like the classic PEG ratio discussed above. The difference with GV is that it is 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 laughably high).
  • Forecast EPS growth rate must not more than halve from one financial year to the next (ie not too erratic).
  • EPS forecasts must have either been upgraded during the past three months or not downgraded in the past three months and had an upgrade in the past year. The EPS forecasts in question are based on predictions for the next 12 months (NTM).

The last year was a rather erratic period for the screen. The selection of 12 made in late June first faced the 2019 summer sell-off, which bottomed out in August. The shares then collectively went on a tear before being savaged by the Covid-19 crash in March. Overall, they finished the year slightly ahead of the market; a 50:50 split between the FTSE All Small and Aim All-Share, which are the indices the screen is conducted on.

 

12-month performance

NameTIDMTotal return (24 Jun 2019 - 3 Jul 2020)
Pan African ResourcesPAF74%
Good Energy GroupGOOD39%
Tatton Asset MgmtTAM25%
M WinkworthWINK16%
Belvoir GroupBLV0.6%
KellerKLR-1.9%
SThreeSTEM-6.0%
Draper EspritGROW-9.1%
Speedy HireSDY-11%
Vertu MotorsVTU-39%
XpediatorXPD-54%
Ince GroupINCE-78%
FTSE SMALL CAP--6.6%
FTSE AIM ALL-SHARE--2.8%
FTSE Small/Aim--4.7%
GV Small--3.7%

Source: Thomson Datastream

 

Since I began running this screen seven years ago it has comfortably outperformed the benchmark set by the indices, with a 99 per cent cumulative total return compared with 47 per cent. But trading in small-caps can be very expensive. As well as normal dealing costs investors often have to stomach large differences between the price a share can be bought and sold at (the so-called bid-offer spread). To inject a bit of realism into the performance numbers I therefore add a fulsome 2.5 per cent annual charge. Taking this into account, the cumulative returns from the screen drop to 66 per cent. 

This year, only two stocks passed all the screen’s tests. To make a decent showing from the screen I’ve therefore included 10 other stocks that have failed one of the screen’s tests as long as it is not the valuation test. The details of all 12 shares and some associated fundamentals are given in the table below. The two shares that pass all the tests are listed at the top of the table and otherwise it is ordered by lowest to highest GV ratio. I’ve also taken a bit of a closer look at one of the shares with full marks, which could be on the cusp of a turnaround.

 

12 cheap small-cap growth plays

NameTIDMMkt CapPriceGV RatioPEGFwd NTM PEDYEV/EBITEV/SalesFwd EPS grth FY+1Fwd EPS grth FY+23-mth MomentumFwd EPS chg (3mth)Fwd EPS chg (12mth)Net Cash/Debt (-)Test Failed
Caledonia Mining Corporation PLCCMCL£166m1,320p0.050.0353.4%72.6841%67%83.33%95%264%$10mNone
De La Rue plcDLAR£200m137p0.170.089-130.6220%31%201.92%0.2%-50%-£116mNone
DWF Group PlcDWF£150m53p0.040.0660.8%80.9970%59%-42.76%-32%-18%-£132mUpgrades
Zambeef Products PLCZAM£23m8p0.080.189-50.3717%37%78.16%--8.1%-ZMW44mUpgrades
Morses Club PlcMCL£68m54p0.080.1355.0%40.72-4%41%50.97%-23%-19%-£19mErratic EPS
Flowtech Fluidpower plcFLO£46m78p0.090.098-90.6443%34%29.17%-17%-38%-£25mUpgrades
Burford Capital LimitedBUR£1,112m493p0.130.1250.7%718.17-1%53%55.62%-22%-27%-$317mErratic EPS
Anglo Asian Mining PLCAAZ£160m135p0.150.2874.2%62.0140%-3%43.62%-52%$9mErratic EPS
Photo-Me International plcPHTM£208m55p0.160.5069.3%40.878%4%43.23%25%-11%£8mErratic EPS
City of London Investment Group PLCCLIG£101m386p0.160.2786.7%72.72-11%56%24.35%4.0%28%£11mErratic EPS
Stock Spirits Group PlcSTCK£475m235p0.170.22133.3%91.6943%6%62.07%5.5%2.4%-€38mErratic EPS
Capital LimitedCAPD£84m62p0.170.3381.7%50.820%29%27.84%-2.5%23%$12mUpgrades

Source: FactSet

 

De La Rue

Shareholders in banknote and authentication group De La Rue (DLAR) have endured a torrid run, with the shares losing nearly four-fifths of their value over the past three years. However, a new management team is buying itself time to turn the company around thanks to: a £100m placing at 110p that is due to complete imminently; £42m cash proceeds from the sale of the company’s international identity solutions business; a new agreement with pension trustees to cut annual top-up payments to April 2024 from £23m to £15m (£25m to 2029 thereafter); and agreement of bank facilities of £275m running out to the end of 2023 for an extra 150 basis points interest and contingent on the £100m fundraising going through. 

With this much-needed financial breathing room, the new top team plans to enact a turnaround plan that it hopes can take the group’s underlying operating margin from 5.5 per cent last year to mid-teens-and-growing by the end of March 2023. The target is also for 9 per cent compound annual revenue growth and sustainable cash inflows to support a reinstatement of shareholder payouts; one of the conditions of the recent bank refinancing was no payouts for 18 months. 

This sounds great. But there is a lot of work to do. The challenge is reflected in the long-term downward trajectory of earnings and cash flows (see table). The plan also will not be cheap to put into effect, with management estimating the total cost associated with restructuring and investment at £80m in total.

 

A key cause of the company’s historical difficulties has been its banknote business. A combination of bad contracts (Venezuela was a big customer), weak demand, tough competition and high fixed costs have pummelled profits and cash flows. The company has also done badly bidding for new contracts. This includes the high-profile loss of its identity solutions contract to print UK passports. That business is now being wound down.

Key to plans for the banknotes business is cost-cutting. The current target is for £36m of savings, but management thinks there could be more to be had. By the end of the turnaround plan, it is envisaged that banknotes will account for about half of turnover and one-third of profit. The lower costs are also expected to make it a more competitive bidder, as well as more reliably profitable.

If all goes to plan, at the end of the three years the rest of the group’s sales and profits will come from operations with much more promising prospects. This includes the company’s polymer currency operations. De La Rue faces far less competition in this market and has established itself a leading position. It boasts a number of customers transitioning several note denominations to polymer – as we have seen in the UK with the £5 note followed by £10 and £20, and with £50 to come. Of the turnaround spending, £15m is earmarked to go into adding polymer capacity to win new customers.

The group’s authentication activities are also showing strong growth. Revenues from this business rose 60 per cent last year to £69m and the underlying operating margin came in at 15.8 per cent. This business provides things such as tax stamps for tobacco products, products to ensure cradle-to-grave traceability to help monitor sustainability, and sophisticated anti-counterfeit brand authentication. Again, growth is not expected to come cheap, with £35m of the turnaround spending aimed at developing products in this division.

Some early encouragement about the turnaround can be taken from recent contract wins and some broker forecast upgrades after three years moving in the wrong direction. 

That said, consensus forecasts are still for a free cash outflow this financial year of £10m as the company invests in growth, pays for restructuring and continues to service the £143m pension deficit – albeit at a lower level. The track record of disappointments also gives reason for caution. And while De La Rue’s customers continue to demand more currency each year, and the company sees no signs of this abating, there is the existential threat of the world going cashless in the future. 

 

That said, even after a mighty share price rebound from March lows, De La Rue’s enterprise value (market cap plus net debt) only represents 0.7 times NTM forecast sales. That suggests there is definitely some serious value on offer if the turnaround plan proves a success and De La Rue can convince the market its refocused operations make it a mid-teen-margin growth play. The company has also said it has seen minimal disruption from Covid-19. Still, this recovery play is heavy on the hope factor at this stage, and hopefully there will be news of the successful completion of the fundraising soon (possibly between the time of writing and publication).