Fourteen cheap small-caps

This screen uses several tests to try to separate the wheat from the chaff based on the approach of famed American contrarian investor David Dreman. That said, Mr Dreman preferred the safety of larger companies to the perils of small-cap investing. Indeed, the ups and downs of this screen over the years suggest its output should be viewed with caution – this column assumes the results of the screens followed are useful as ideas for further research rather than off-the-shelf portfolios. The criteria used by the screen vary slightly depending on which valuation measure shares look cheap against 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), price-to-book-value (PBV) or the genuine value ratio (GV). The GV ratio is similar to a standard price/earnings growth (PEG) ratio in comparing an earnings-based valuation with earnings growth potential, but it also factors in dividends and debt. 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. For shares qualifying based on a low GV ratio, I have eliminated any companies with an average forecast growth rate over the next two years of over 50 per cent, as such strong growth could prove unsustainable.

■ 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. Companies qualifying based on our GV ratio must pass both tests.

■ 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.

Despite the criteria’s attempts to focus screen results on safer small-cap value bets, the range of returns from last year’s 24 share picks illustrates that risks remain high. For example, the somewhat sceptical tone of my write-up of clothes retailer Bonmarche last year appears to have been well founded given its negative total return of 81 per cent. The other company I highlighted in last year’s screen, Produce Investments, showed the upside of targeting small-cap value, though. It succumbed to a £53m (187p a share) private equity bid last September. The business’s highly weather-dependent profits made it look an odd fit with a stock market listing given the importance equity investors tend to put on consistency of earnings.

Overall the 24 shares selected 12 months ago delivered a 2.6 per cent total return compared with a negative 1.2 per cent from a 50:50 split of the FTSE Small Cap and Aim All-Share indices (the two indices screened). This takes the cumulative total return from the screen since I began to run it six years ago to 69.1 per cent, which compares with 59.3 from the Small Cap:Aim split. However, there are high costs associated with trading small-caps because the illiquidity of such shares often means a large difference between the price at which investors are able to buy and sell shares at (the bid-offer spread). After taking the important step of factoring in these high costs with an annual charge of 2 per cent, the cumulative total return drops to 49.8 per cent – some way below the market return represented by the indices.

Last year's performance

This year 14 shares passed the screen’s tests. Details of these shares along with some key fundamentals can be found in the table below (a downloadable excel version of the table is available by clicking on the accompanying link). I’ve taken a closer look at the share from the table that appears cheapest based on its price to forecast earnings. Hopefully my write-up helps illustrate some of the reasons a share like this, which on the surface holds promise, also has some sound reasons for its cheapness.

Source: S&P CapitalIQ. *All FX converted to £

Norcros

On the face of it, bathroom and kitchen products group Norcros (NXR) looks inexplicably cheap. The company boasts a very high underlying return on capital employed (ROCE) of 18 per cent for its last financial year (to the end of March 2018) and aims to sustain ROCE at above 15 per cent over the medium term; ROCE is often regarded as an important measure of a company’s quality. Meanwhile, underlying operating margins have been rising and stood at 9.1 per cent last year. Sales and profits have been growing at an impressive rate (a three-year compound annual growth rate of 11 and 14 per cent respectively based on S&P CapitalIQ data). And the brand-focused group has an opportunity to take the role of consolidator in the fragmented markets it serves with the aim of building and strengthening market-leading positions.

Meanwhile, despite a sluggish economic backdrop in its key geographies of the UK and South Africa, management expects to meet expectations for the current year. The performance has been supported by growth in trade sales, which has helped mitigate the negative impact of restructuring at DIY retailer Kingfisher. Meanwhile, although debt levels have been rising over recent years, net borrowing looks reasonable. What’s not to like one may ask?

A forward price/earnings (PE) ratio of less than seven is a clue that anyone feeling buoyed by the bull case set out above should proceed with some caution. The most obvious issue faced by Norcros is the trading outlook, which is heavily reliant on the replacement, maintenance and improvement (RMI) and new-build markets in both the public and private sectors.

In South Africa (which generated about a third of both sales and underlying profit in 2018), the economy is emerging from a short recession and growth expectations, while improved, remain muted. Meanwhile, in the UK, Brexit uncertainty weighs on consumer confidence, the private housing market is showing signs of slowing, and local authority budgets are tight with spending diverted towards post-Grenfell safety programmes.

While a key long-term opportunity for Norcros lies in the fact its end markets are fragmented, in the short term this may mean Norcros faces competitors that are more willing to slash prices as trading deteriorates. What’s more, given the company manufactures many of the products it sells, fixed costs stand to increase the pain from any downturn.

While the company told investors last month that full-year results would be in line with expectations, the interim result did give investors some cause for concern in the form of rising stock levels. In part, Norcros attributed this to worse than expected export sales, which is a worry. More positive reasons given for higher stock levels were new product launches and new business wins.

Another consideration for investors is the question of what costs are left out from the very attractive “underlying” returns reported by Norcros. The company is far from alone in how it presents its underlying figures, but while underlying numbers can give a clearer impression of the general direction of travel, investors also need to consider returns from a more warts-and-all perspective. In particular, costs associated with acquisitions are an important consideration given Norcros’s acquisition strategy, which has seen it buy four businesses over the past four years. Indeed, acquisitions are a key driver of the group’s growth and in general investors are less willing to pay up for growth based on deals than for growth from internal investments.

Factoring in acquisition costs of £4.3m (expenses associated with doing deals and the amortisation charge to reflect past acquisition spending) and pension administration costs, ROCE comes in at just under 11 per cent. That level of return is not terrible by any means, but it’s far less impressive than the company’s stated underlying figure. My ROCE calculation ignores £2.1m of restructuring costs at the company’s UK tiles business – a second round of restructuring in two years.

Recent acquisitions include a major £60m purchase of shower enclosures company Merlyn, which was completed early last year. This was part-funded by an equity fundraising at 172p (a 6 per cent discount to the share price at the time) that increased the share count by nearly 30 per cent and included an open offer element that was undersubscribed. Meanwhile, last month Norcros completed the ZAR215m (£12.1m) purchase of South African bathroom and kitchen products business RAP Plumbing.

Norcros’s defined-benefit pension represents another major consideration for would-be value investors. Overall pension costs are currently close to an expected peak of about £20m a year, but these costs will only tail off slowly. Encouragingly, though, top-up pension payments, along with changing assumptions about future pension requirements and investment returns, have seen the reported deficit drop markedly in recent years from £63m in March 2017 to £29m at the end of the half-year to September 2018. Nevertheless, pension liabilities remain huge compared with the size of the company at £428m; an ongoing risk for shareholders.

Another liability that is not captured by reported net debt is the company’s debt-like lease obligations, which now need to be reported on the balance sheet following a change to accounting rules. Valuing leases at seven times last year’s rent bill puts a value on the liability of £43m.

There are a number of risks associated with owning shares in Norcros, which helps explain the apparent cheapness. But for a buyer, the opportunity lies in the potential for management to improve the perceived quality of the company while getting lucky with trading conditions in the meantime.