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Fourteen High Quality Small-caps

My High Quality Small-caps screen has had to have a Covid-19 facelift, and that may be no bad thing.
September 2, 2020

The impact of Covid-19 has meant I’ve recently needed to change the criteria used by a number of the screens I run, and this week I am having to make a number of alterations to my High Quality Small-cap stock screen.

In the case of this screen, the necessity of change in order to generate positive results is perhaps no bad thing. I changed the large-cap version of this quality screen a few years ago and the results have been good, whereas the small-cap screen using the old criteria has failed to impress over the same period. 

Indeed, last year’s performance (see table) is far from great. Arguably it justifies my limited enthusiasm about the quality credentials of the two shares that passed all the screen’s tests a year ago (Character Group and Billington). 

 

12-month performance

Name TIDMTotal return (31 Jul 2019 - 21 Aug 2020)
Gamma CommunicationsGAMA52%
Belvoir BLV31%
Arcontech ARC22%
Water IntelligenceWATR3.3%
Inspiration HlthcrIHC-1.4%
TracsisTRCS-2.6%
D4T4 SolutionsD4T4-3.1%
BillingtonBILN-3.1%
Churchill ChinaCHH-35%
Character CCT-36%
ReddeREDD-41%
FTSE Small Cap--5.5%
FTSE Aim-3.9%
FTSE Small/Aim--0.8%
HighQualSmallCaps--1.3%

Source: Thomson Datastream

 

Nevertheless, from a longer-term perspective the screen continues to boast a good record with a cumulative total return since inception in 2012 of 154 per cent compared with 79 per cent from a 50:50 split between the FTSE All Small and Aim indices. While the screen results are meant as a source of ideas for further research rather than an off-the-shelf portfolio, if I factor in a 2 per cent annual charge to represent high small-cap dealing costs, the cumulative total return drops to 116 per cent. 

 

 

The changes I am making to the screen involve: (i) making the key quality criteria more demanding (return on equity and operating margins now need to be in the top quarter rather than top half of stocks screened); (ii) dropping the requirement for sustained improvement in quality due to the impact of Covid and the breadth of the hit across sectors; (iii) changing the forecast growth criteria to one based on the next 24 months to account for expectations of a short-term earnings drop for most companies; (iv) softening the valuation criteria as 'cheap' quality shares, while always rare, currently seem very much a thing of the past. The screen’s amended criteria are:

  • PE ratio above bottom fifth and below top fifth of all stocks screened.
  • Earnings growth forecast over the next 24 months.
  • Interest cover of five times or more.
  • Positive free cash flow.
  • Market capitalisation over £20m.
  • A top-quarter return on equity (RoE) in each of the past three years.
  • A top-quarter operating margin in each of the past three years.
  • Operating profit growth over the past three years.

In total 14 shares passed the screen’s revamped tests, 12 of which herald from Aim. The results are given in the table below along with fundamental data including the price/earnings ratio (PE) based on forecast annual earnings per share (EPS) 24 months out (referred to in the table as Fwd PE 2-yr rolling). While forecasts that look so far ahead should always be taken with a liberal pinch of salt, especially for under-researched small-caps, this PE still hopefully gives a vague idea of potential valuation after the worst of the Covid hit is out the way. I’ve taken a look at one of the shares in more detail below. It displays some enticing characteristics as a quality-growth play, but also has some noteworthy issues that highlights problems associated with dropping the screen’s tests for improving quality.

 

14 High Quality Small-caps

NameTIDMMkt CapPriceFwd PE (1-yr rolling)Fwd PE (2-yr rolling)Fwd DY (1-yr rolling)DYEBIT MarginROCEFwd EPS grth +24 mth3-mth Fwd EPS change%12-mth Fwd EPS change%3-mth MomNet Cash / Debt(-)*
Caledonia Mining Corporation PLCCMCL£158m1,428p541.9%1.8%38%27%112%7.1%-18%-£9m
Fevertree Drinks PLCFEVR£2,389m2,055p44361.0%0.7%28%35%13%-7.4%-36%-1.2%-£127m
Advanced Medical Solutions Group plcAMS£518m241p32240.8%0.5%27%15%12%-47%-55%-4.2%-£54m
Hollywood Bowl Group PlcBOWL£237m151p15113.6%3.2%24%23%2.1%5.4%-75%-21%£191m
ABCAM PLCABC£2,698m1,248p52410.8%0.8%23%19%45%-18%-47%-15%-£15m
Medica Group PlcMGP£149m134p18131.8%0.5%22%23%43%-9.1%-31%4.3%-£4m
Nichols plcNICL£460m1,248p22193.0%0.8%19%27%35%-11%-37%-3.5%-£47m
RWS Holdings plcRWS£1,670m607p27251.6%1.5%18%13%52%1.1%-5.0%-6.0%£57m
iomart Group plcIOM£393m360p21201.9%2.4%15%10%43%-1.9%-16%7.8%£58m
SDI Group plcSDI£67m69p1817--15%14%54%2.8%2.8%28%£7m
Gamma Communications PLCGAMA£1,502m1,580p30270.8%0.8%14%32%59%4.8%33%30%-£41m
Watkin Jones PlcWJG£378m148p875.9%3.8%14%27%31%-1.0%-2.7%-13%£108m
Churchill China plcCHH£112m1,015p34161.5%0.6%13%27%29%--86%-18%-£16m
Oxford Metrics PLCOMG£117m93p16162.5%2.0%10%16%156%0.0%16%8.1%-£9m

*All FX converted to £

Source: FactSet

 

Medica

Medica (MGP) offers an outsourced radiology reporting service based on MRI, CT and thin-film scans sent by its clients. The main areas from which the business generates revenue are its super-fast out-of-hours reporting and reports on routine scans. 

There are some features of the business that suggest it could offer the magic combination of long-term growth coupled with high returns on its capital invested; something often referred to as a 'quality compounder'. However, there are also some noteworthy risks that seriously temper the 'quality' credentials and help explain the lacklustre share price performance since the 2017 float.

Starting with the positives, and looking past the hiatus in demand caused by Covid-19, Medica’s end market is growing. The company’s principal client is the NHS, which is increasing outsourcing because of overstretched radiology departments.

It is estimated that 97 per cent of radiology departments are unable to meet demand, while increased focus on early diagnosis and rising accident & emergency admissions have contributed to a 30 per cent increase in the diagnostic-reporting workload over the past five years. While the NHS is attempting to pool radiology resources to address the problem, the underlying capacity issues means outsourcing growth is expected to continue. This underpins Medica’s expectations that, Covid aside, its business is capable of sustaining a double-digit organic sales growth rate. The track record supports this, although margins have recently been slipping (see chart).

 

 

The pause in non-Covid hospital visits this year has been a major blow, but activity is now picking up and there is the potential that the big backlog of work could prove a temporary boon for Medica as life gets back to normal. Also, Medica’s net cash position, £13m of borrowing facilities and a flexible cost base means it should prove resilient even if there are further setbacks.

Key to Medica maintaining its leading market position (it has about 40 per cent share) is technology and recruitment. On the technology front, it operates a platform that allows its network of radiologists access to relevant patient records, which enables quicker and better reporting. The system also provides significant flexibility for radiologists, allowing them to work from home anywhere in the world. And systems have to comply with its clients’ high governance standards, which makes customer relationships 'sticky' and provides something of a barrier to entry.

Radiologist recruitment and retention is a key constraint on growth and recently the company has been looking overseas to boost its 435-strong radiologist network. Still, the high level of experience required to do the job and the need for General Medical Council approval makes finding the right people a real challenge. While this means employees have considerable power and puts a constraint on growth, the flipside is that Medica has a competitive advantage in operating the largest consultants pool outside the NHS. 

Following the appointment of a new chief executive, Dr Stuart Quin, last year, the company is undertaking a £5m-£6m investment drive to try to build on its existing technology and boost recruitment. Medica has also gone into partnership with artificial intelligence firm Qure.ai to try to improve the efficiency of workflow and aid diagnosis. 

The partnership is particularly welcome as there are fears disruptive technologies such as AI could see Medica left behind. Still the fact that radiologists remain liable for reports currently puts limits on the level of automation that can occur regardless of how advanced the technology becomes. 

The new boss also wants to use the company’s existing platform and relationships to move into new areas of telemedicine as well as offering new teleradiology services. The company is looking to acquisitions as a potential means to move into new markets.

So, there is a decent growth story alongside a high-margin business. And as illustrated by the group’s high return on capital and a good track record of cash generation, the investment required to fund growth is relatively low.

However, there are also reasons to be wary about the quality of the company’s earnings. Medica has a powerful key customer in the NHS and contract negotiations have seen gross margins move downwards (49 per cent to 47.8 per cent last year) as volumes have risen. Attrition is expected to continue at this rate for the next few years.

The company’s pricing power is not helped by the fact that, despite the competitive edges it boasts – sticky relationships and access to talent – it still has plenty of competitors, including highly innovative, would-be disruptors. Adding to concerns about competition, growth over recent years, while impressive, has largely relied on getting more work from existing contracts rather than winning new ones. The shortage of radiologists also limits its ability to control its biggest cost – wages.

A portion of the group’s increased investment is being booked as day-to-day expenditure, which means operating margins are feeling a bigger squeeze than gross margins. Before Covid, the company had underlying operating margins of 20 per cent penciled in for 2020 compared with 24.3 per cent in 2019.

Dependence on a large single customer creates other risks aside from pricing power. The loss of a large contract with a trust and changes to NHS-wide procurement procedures could have a major impact. So, too, could the NHS’s adoption of new disruptive technology. 

Revenue recognition, a bane of outsourcers, is also of note given the company’s auditor, Grant Thornton, highlights the policy of recognising revenue as soon as a report is submitted as its biggest concern. Still, debtors (amounts owing) have been steady at just over a fifth of sales for a few years, and having the NHS as a client provides some assurance that bills will be paid.

On some levels there’s quite a lot to like about Medica given the growth and high – albeit declining – margins. While there is a fair bit that could go wrong, a low-teens multiple of forecast EPS in two years' time (post the Covid hit) does not look bad value for the growth prospects. Upgrades based on a Covid-induced backlog of work could lift the shares, as could a canny acquisition, or strong progress with its AI partner. Its NHS relationships and platform could also make it a target itself for another telemedicine group. So while there are noteworthy risks, the investment case still has some merits.