Two Cheap and Decent Small Caps

2018 PERFORMANCE

Source: Thomson Datastream

However, this screen includes some criteria based on valuation and, as I’ve previously remarked upon, value-focused screens have generally done very poorly recently. Another consideration when assessing the screen’s performance last year is that six of the seven stocks heralded from the Aim market and the FTSE Aim index has had a dire run over the past 12 months.

The screen’s criteria can be regarded as ones that hope to identify decent quality companies, rather than those of truly knock-out quality. There are a number of boxes shares have to tick aimed at improving the chances of finding companies of reasonable merit. The full criteria are:

• PE ratio above bottom fifth and below top fifth of all stocks screened.
• Lower than median average GV ratio.
• Earnings growth forecast for each of the next two years.
• Interest cover of five times or more.
• Positive free cash flow.
• Market capitalisation over £20m.
• Higher-than-median average return on equity (RoE) in each of the past three years.
• Higher-than-median average operating margin in each of the past three years.
• RoE growth over the past three years.
• Operating margin growth over the past three years.
• Operating profit growth over the past three years.

The cumulative performance of the screen over the seven years I’ve run it has been good, with a total return of 160 per cent – double the 80 per cent from the market. But the headline figure does not tell the whole story as smaller company shares can be very costly to deal in. While the screen results presented in this column are regarded as ideas for further research rather than off-the-shelf portfolios, if I apply a notional 2 per cent annual charge to reflect real-world costs of shifting holdings based on the screen’s yearly output the cumulative total return drops to 126 per cent.

This year, only two shares passed all the screen’s tests, both of which herald from the Aim index. This is somewhat surprising given the length of our current bull market, which has led to many cyclical companies displaying financial characteristics usually associated with quality plays. To generate a higher number of positive results I’ve included shares in the table that pass all the screen's key quality tests (above average and improving RoE and Ebit margins) but fail one of the other tests. The tests failed are detailed in the table. I’ve also taken a look at the two shares passing all the screen’s tests. Neither of these companies actually seem that high quality to me, although both businesses look decent enough in their own right.

Source: S&P Capital IQ

The Character Group

The fundamentals used by my High Quality Small Cap screen to select shares would seem to suggest Character (CCT) is significantly undervalued given its quality. It boasts a healthy operating margin and strong return on equity, yet on a cash-adjusted basis the shares are valued at just 9.5 times expected earnings for the 12-months to the end of August 2020 and are forecast to yield 5 per cent. But fundamentals only tell one so much, which is why most people only like using screens as a first step in an investment process.  

In the case of Character, a designer and distributor of toys, its business model suggests that the quality of earnings may not be as strong as a casual look at the fundamentals would imply. 

There are three key issues that stand out. Firstly, demand for toys is cyclical, which means any economic downturn is likely to be painful. Indeed, 10 years ago, during the financial crisis, the company reported a loss in 2009 and cut its dividend. That said, Character outsources the manufacture of its toys, mainly to Chinese factories, which reduces operational gearing (the sensitivity of its profits to a sales slowdown). Overseas manufacturing does mean sterling weakness is an issue, though. While recent acquisition activity has attempted to mitigate the impact of Brexit on international sales (18 per cent of the total), the event could still cause problems for the overseas business as well as for the supply chain and domestic demand.

The second standout  consideration regarding Character’s 'quality' credentials is that toy retailers are going through a period of disruption. The collapse of Toys R Us in 2017 caused a temporary trading hit, which led to falling turnover in each of the past two financial years. Similar events in the Nordic region earlier this year have affected Character’s overseas interests. 

Finally, but perhaps most significantly, many of the company’s biggest hits, such as Peppa Pig, are based on licences to create toys based on TV and film characters. In other cases, Character is simply the exclusive UK marketing and distribution partner for overseas toy companies. This means that much of the intellectual property that underpins Character’s business is actually owned by other companies. The loss of licences and distribution agreements, or changes to contract terms, have the potential to have a major impact. 

These risks help explain why the valuation of Character’s shares should not be considered to be as outlandishly cheap as first may seem. But the company’s track record does suggest it is good at what it does. What’s more, its UK market leadership in preschool toys helps to support strong relationships with intellectual-property owners. 

The company is also exploiting trends towards impulse purchases through the development of toys such as Cakepop Cuties (whatever they are), although the disposable-nature of some of these fads seems rather at odds with growing consumer concerns about plastic waste.

With the Toys R Us setback out of the way, growth is expected to resume this year. Meanwhile, management hopes to use recent lessons from the UK to make a virtue out of disruption in the Nordic toy market. 

Earlier this year, to help secure its place in post-Brexit EU markets, Character purchased a 55 per cent stake in the region's largest toy distributor, Proxy, for up to £3.3m. However, Proxy has been hit by the collapse of a major retailer in the region. Character has stepped in to help Proxy with working capital finance and believes that in the medium term the disruption presents the opportunity to win a number of valuable exclusive distribution agreements.

In all, while it may be a push to describe Character as 'high quality' due to its cyclicality and reliance on other companies' intellectual property, for what it is, it looks a good business. Outsourced manufacturing provides Character with useful flexibility should it suffer any market upsets. The company also boasts a solid track record for cash generation and a robust balance sheet, while the shares’ rating is not challenging and the dividend yield is attractive.    

Billington

Billington (BILN) fabricates structural steel (accounting for 91 per cent of sales and 73 per cent of profit) and hires out temporary hoardings and safety equipment. Arguably, regardless of what financial fundamentals tell, these lines of work make it even less deserving of a true 'high quality' badge than Character. In fact, relatively modest operating margins of 6.5 per cent already suggest this is not a standout quality play. Additional reasons to question the 'high quality' billing are that as well as having cyclical end markets, the type of work the company undertakes typically requires it to take on a fair amount of balance sheet risk. Indeed, compared with profits – although not sales – the company has quite high levels of stock and work in progress (stock and work in progress stood at £12m at the end of 2018) and outstanding invoices (receivables of £7.5m). Meanwhile, the need to hire up-to-date kit means the company can’t slack on capital spending. End markets are competitive, with increased industry capacity expected to keep a lid on margins for the time being. 

That said, over recent years Billington’s progress has been impressive. By focusing on costs, and bringing value-added services in-house, the company has driven operating margins up from 1.9 per cent to 6.5 per cent over five years. Meanwhile, revenues have almost doubled over the same period. 

And despite the business’s previously mentioned capital needs, the company has also built up a solid net cash position, which provides it with a reassuring buffer to working capital. It’s also worth noting on the working-capital front that stock and receivables of £19.5m are balanced out by payables (money and services owed by Billington to others) of £18.7m.

But given Brexit uncertainty and troubles in the construction sector, it’s fair to ask whether the good times will continue. Perhaps surprisingly, recent newsflow from the group has been very encouraging. 

Having started 2019 with what it described as an “unprecedented” level of secured work, in early June Billington announced £30m of contract wins. The company has also pointed to good conditions in power and infrastructure markets, where it has a strong presence, and its work in Europe is benefiting from the weakness of sterling. Comments about rising structural steel industry capacity are a concern, though.

Still, while the nature of Billington’s business means it is hard to hand-on-heart describe it as 'high quality', it has been making impressive progress and seems to still have wind in its sails. What’s more, as with Character, the valuation is low to reflect its business's inherent risks.