Seven cheap small cap growth plays

The root cause of the problem in both cases is a market-wide lack of forecast earnings growth. Lockdown has created some rather novel circumstances and many companies that would normally be fairly resilient in a recession stand to get their earnings smashed in the coming year. For screens that require earnings growth, or seek companies with shares that look “cheap” compared with forecast growth, this is a real problem.

This week’s screen requires both forecast earnings growth and shares that look cheap based on the forecasts. The screen is based on the investment approach outlined in the classic investment book The Zulu Principle by Jim Slater. The screen's performance over the years has been very strong, and the story of how this has been achieved helps explain why tinkering with this screen is particularly vexing.

One of the things Mr Slater’s book became best known for was popularising the price/earnings to growth (PEG) ratio in the UK. Soon after I started following the screen in 2013, I ran into trouble finding stocks that hit the screen’s PEG criteria along with all of its quality criteria. I decided to relax the quality criteria in response, but the performance of the screen on this basis was not great. 

Then, thankfully for readers of this column, Mr Slater himself  made an intervention, writing to tell me I was doing things back to front and that when valuations were higher, investors should “double down” on quality and loosen the valuation criteria. With the advice taken on board, the screen’s performance then went stratospheric. The inflection point is clear in the graph below. Even over the past 12 months when one may have expected “cheap”, growth-focused small caps to take a pounding, the screen has managed to outperform.

12-month performance

Source: Thomson Datastream

But the quandary I am now faced with is how far to go in loosening the screen’s valuation criteria. To make the PEG test flexible I had it so the ratio should be in the bottom quarter of stocks screened. Even if I move this criteria to the bottom half of PEGs I only boost the results from one to three stocks. That said, at the moment PEGs are so low on average, that the two extra stocks identified on this basis also look cheap based on the classic rule of thumb that a PEG below one is attractive, and one of them even meets the original Zulu test for a PEG below 0.75. 

If I move the PEG test to being in the cheapest three-quarters of stocks (ie, outside the quarter most expensive) then the output of the screen increases to seven stocks. Again, the PEGs are not eye-wateringly high with only one company on the list with shares trading on a PEG of over 2 times. 

A key source of the problems faced by the screen is that it is hard to even generate a PEG ratio for many companies at the moment because forecast growth rates are negative. For the smaller companies that this screen focuses on, an added problem is that forecasts may be particularly unreliable due to thin broker coverage. Readers should keep this in mind when looking at the screen results.

For many companies the earnings setback is likely to be a temporary phenomenon and when the recovery comes the screen will face the problem of stocks with unrepresentatively high forecast growth as earnings bounce back over a relatively short period.

The seven stocks passing the screen on the loosened-and-loosened again criteria are shown in the table below ordered from lowest to highest PEG. I’ve taken a closer look at the stock that looks cheapest, Stock Spirits, but all is not quite what it seems on the PEG front.

Seven cheap small-cap growth plays

Source: FactSet

Stock Spirits (STCK)

Stock Spirits made a useful contribution to the Slater screen’s performance last year and is back once again as the only stock now passing all the screen’s tests. 

One thing to note at the outset is that the very low PEG associated with Stock Spirits shares is a product of how the screen has interpreted a change in the group’s year end from 31 December to 30 September. In fact, on a like-for-like basis, EPS is expected to drop a little in the current financial year. But it is often worth playing the hand one is dealt and there are reasons to think Stock Spirits could be a case in point based on recent trading and longer-term potential. Importantly, on the valuation front, the forward PEG (based on a P/E using next year's forecast EPS and average earnings growth predicted in the two years following) is attractive at just 1.

The Eastern Europe-focused spirits maker and distributor has had a pretty good crisis. It generates 55 per cent of sales in Poland, which is the world's fourth-largest vodka market and where Stock owns the number two vodka brand. It also sells a range of other branded spirits as well as distributing premium third-party brands (which represents less than a tenth of group profits). 

Importantly, as far as the current crisis goes, in Poland Stock makes minimal sales are made through clubs, bars and restaurants – the “on-trade” – which have been badly hit by lockdown. And at group level only around 15 per cent of sales are on-trade. The badly-hit duty free market is also only a very small part Stock's business. 

There are also some benefits of on-trade weakness for the company. People have not stopped drinking just because they are unable to go out, which means off-trade demand, where Stock is focused, has increased. In Poland consumers have also been more prone to buy through smaller outlets from whom trading terms tend to be more favourable. 

The company has also seen limited supply chain disruption thanks to its focus on local sourcing. Even its grappa distillery in Covid-19 savaged Lombardy has been able to remain open.

 A strong first half – 15 per cent organic sales growth, a 21 per cent total sales increase, and  41 per cent EPS growth – prompted a string of forecast upgrades. Trading in Poland was particularly good, reflecting the off-trade focus. Meanwhile the Czech operation was boosted by an acquisition made this time last year. Italy was more difficult both due to its dependence on on-trade sales and tough competition over Christmas. The company also wrote down €14.2m associated with a disappointing Irish Whiskey joint venture. 

Recent trading aside, Stock has something of a chequered history. The group had a complete overhaul of top brass in 2016 and 2017. The change came following activist intervention in the wake of a substantial loss of market share in Poland soon after the company’s initial public offering in 2014. The problems arose after the company raised prices in response to an increase in Polish excise duty while a deep pocketed competitor, called Roust, held prices low to become market leader – a position it still enjoys. 

The market in Poland remains very competitive so it is encouraging that a new excise rise at the start of this year in both Poland and the Czech Republic didn’t cause any problems. Indeed, Stock continues to win back share, although chiefly at the expense of Poland’s number three spirits player.

Margins have been moving in the right direction recently, too. That said, the operating margins and return on capital employed (see table) are hardly stand out in this sector. Investment in a new distillery and on-going efforts to establish premium brands that appeal to younger drinkers could help. The biggest immediate plus, though, would probably come from less price competition, not that there is any clear sign of this emerging. The Polish alcohol market has characteristics that suggest it could be more profitable for big players based on a blanket advertising ban which puts leading brands and distributors in a powerful position. On the flip side, without ads it is hard to create and exploit brand value.

The company is also looking to grow through acquisitions. Broker Shore Capital reckons the group has potential “firepower” of €100m. It also has access to €70m of non-recourse invoice financing which is currently unused. This could prove a useful backstop should times get really tough. The company is working to improve payment terms and been reducing its days of sales outstanding (days to get paid) which stood at 33 last year*. 

Lockdown and competition could knock the group, but on the whole there may be more reasons to hope things get better from here rather than worse. The group’s strategic approach seems to have been working and the crisis could result in some attractive acquisition opportunities. Meanwhile, the shares’ valuation looks far from challenging with a decent dividend to boot.