Eight high-octane small-caps

This screen is based on an intriguing paper published in 2015: 'Leverage Small Value Equities' https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2639647. The research is fascinating because it flies in the face of 'value' investing orthodoxy. Importantly, it does this while at the same time making plenty of sense. In fact, the brains behind the paper were so convinced by their findings they went on to found US quant firm Verdad Capital.

The steroids this screen guzzles are debt and 'value'. The approach aims to simulate private-equity-style returns in public markets. The big idea underpinning the high-debt, low-valuation approach is that much of private equity’s historic success can be traced back to buying companies on the cheap with lots of borrowed money. The argument is that the historic outsized returns from private equity come down to the subsequent deleveraging.

The reason this flies in the face of value investing orthodoxy is because most value investors like to have a so-called 'margin of safety'. A margin of safety is a concept dating back to the teachings of Benjamin Graham, the father of value investing. It is meant to protect value investors from irrecoverable damage being done to their capital. Essentially, it means investors can stay in the high-risk game when things go wrong – as they inevitably do. Key to maintaining a margin of safety is avoiding highly indebted companies.

'Cheap' shares are often cheap for a reason; so-called value traps. And when companies are in long-term trouble, it is the value of the shares that get wiped out first. This is because shares are the element of company financing that tend to have the lowest claim on earnings and assets. The risk of shareholder value being wiped out increases as the level of higher-ranking claims – ie debt – rises.

But while the margin-of-safety logic is strong, the screen’s methodology outlined in the 'Leverage Small Value Equities' paper seemed to have minimised the potential pain based on the result of backtesting from 1965 to 2013. During that time, the top 25 ranked stocks produced an average annual return of 25.1 per cent. It did this by focusing on cheap indebted companies that were also showing signs of operational improvement (rising sales to total assets) and were reducing debt levels. 

Still, the pandemic has tested the high-risk approach to the limit. Who would have wanted to head into March 2020 holding shares in highly indebted and generally low quality companies? On that basis, the results from last year’s 10 stock picks were not quite as cataclysmic as I had expected. They were terrible all the same. A 22 per cent negative total return compared with a positive 1.5 per cent from the market (a 50:50 split between the FTSE Small Cap and Aim All Share). While it is early days with this screen, its output does seem to be characterised by some massive wins counterbalancing many abject failures. In the past 12 months Shanta Gold (SHG) was the stand-out success, as it magnified the price surge experienced by the yellow metal. 

12-month performance

Source: Thomson Datastream

On a cumulative basis the screen has produced a positive two-year total return of 2.7 per cent compared with a negative 8.7 per cent from the market. However this does not account for any dealing costs. Were this approach let loose in the real world, cost would be high given the low liquidity of many small caps. While this screen is considered a source of ideas for further research (or a spectator sport for those without high risk thresholds) rather than an off-the-shelf portfolio, if I factor in a 2.5 per cent annual charge to reflect notional dealing costs, the cumulative return drops to a negative 3.1 per cent. 

The screening criteria, which I’ve adapted from the original paper to make a better fit with UK markets, are:

• Among the cheapest quarter of stocks based on enterprise value (EV)/ Earnings before interest, tax, depreciation and amortisation (Ebitda). EV is calculated using the basic method of adding net debt (including preference shares) to market capitalisation.
• A market cap of less than £750m, but more than £25m.
• Net debt to EV higher than the median average of all companies with net debt.
• Improving asset turnover (sales to total assets) over the past 12 months.
• Falling net debt over the past 12 months.

This year eight stocks have met all the criteria. Three-quarters of these are effectively highly sensitive plays on the price of commodities: oil, gold and energy. While highly speculative, this is an interesting feature because positive swings in commodity prices can have big impacts on profitability and consequently debt paydown. In addition the screen has picked Restaurant Group (RTN), which is shrouded in lockdown-related uncertainties, and HSS Hire (HSS). HSS perhaps has a bit more clarity in its outlook. I’ve provided a write-up below on HSS to give a taster of the screen’s output. The company, which has cropped up every year I have run the screen, also provides an insight into how intractable high debt can be.

8 Small-Caps On Steroids

Source: FactSet

*FX converted to £

HSS Hire

This screen just loves HSS Hire (HSS). It has highlighted the construction equipment rental company each of the three times I’ve run it. However, so far it has only suffered for its devotion. I’ve also looked at the company each year and continue to struggle to find much to like about its situation. But from this screen’s perspective there is undeniably a big upside if the company can get its business performing and its debt down. Are there any signs this is happening, though? 

The first alarm bell that is likely to ring for anyone looking at HSS’s recent results announcements is the focus management puts on cash profits (also known as earnings before interest, taxation, depreciation and amortisation, or Ebitda). This screen also focuses on cash profits, but it is not the most useful measure for all companies. I’d regard HSS as a case in point.

Cash profits do not account for either interest payments (the 'i' in Ebitda) or depreciation and amortisation (the 'da'). Because HSS operates a highly capital-intensive business (it spends lots of money on equipment to rent out) and is also heavily indebted, both 'da' and 'i' are of crucial concern to investors: 'da' being the accounting charge relating to historic investment and 'i' providing a measure of the cost of debt servicing. When these are factored into the mix, the company’s profits from last year turn into a small loss after tax, excluding exceptional items and a one-off profit on a large disposal.

True, the fact that 2019 saw the group boost gross profits by about £1m thanks to higher turnover and shave about £4.5m from distribution and admin costs is positive. But it is not as encouraging as a reported 6.6 per cent rise in adjusted cash profit to £64m may at first suggest. Indeed, what was going on further down the 2019 income statement was arguably far more noteworthy for shareholders. 

In particular, the pre-exceptional finance charge for the year rose from £20.4m to £22.6m despite a large reduction in net debt. This reflected a refinancing in July 2018 which has left HSS with a fully drawn £182m senior financing facility charging a whopping Libor plus 8 per cent. The finance charge the year before the refinancing, 2017, was £13.7m. 

Exceptional charges were once again significant last year at £6m. And a £500,000 fall in the group’s depreciation charge is less a reason for celebration and more a cause to worry that balance sheet strain is resulting in underinvestment in this very capital-hungry business. 

The big positive for both the balance sheet and profits in 2019 was the sale of HSS’s UK Platforms business (along with £5.3m debt) in January that year. This led to the group reporting a one-off 14.8m gain as well as booking cash proceeds of £45.6m. The disposal largely explained the £56m fall in net debt to £180m. However, it has also taken a large chunk out of profits (31 per cent of 2018 underlying operating profit and £4.1m profit after tax).

Trading during lockdown was unsurprisingly terrible, but the company’s last update suggested business was picking again up fast. Government’s expressed enthusiasm for “build, build, build” should also help. Half-year results to 30 June and further detail on trading should be published soon. The company was able to point to £67m of headroom on its borrowing facilities in May. Meanwhile, capital expenditure plans were under review.

From a longer-term perspective, trading may benefit from recent investment to improve customer service and the business’s digital presence. However, actual rental-income growth in 2019 was a pretty uninspiring 1.3 per cent with lower-margin training turnover, which rose 14 per cent, the key contributor to an overall increase in turnover of 3.9 per cent.

It is hard to see how HSS can dig itself out of its debt hole without outside help. Cutting the cost of the debt would relieve a sizeable millstone. The disposal may have helped reduce borrowings substantially in 2019, but earnings power is reduced and debt costs are stubbornly high. What’s more, this trick can’t be repeated. 

Indeed, bar the debt reduction from the disposal, little progress has been made in reducing borrowings since private equity owners floated the company in 2015 at 210p – about 10 times the current price. Meanwhile, capital expenditure has remained persistently below depreciation suggesting ageing assets. And sales and profit progress has also failed to materialise (see charts).

The tapped-out valuation means a strong post-lockdown recovery could boost the shares. But beyond this I struggle to see any indication of how the 'steroids' that have been taken are going to get these shares pumped. Maybe the interim results will offer something stronger.