Digging deeper in to small caps to find quality shares at appealing prices

With the FTSE Smallcap index leaping by 20% this year, good quality small cap companies trading at attractive prices are proving harder to find. But despite a rash of surging share prices, there are still ways of finding potentially strong companies with eye-catching valuations. For the investor prepared to kick a few tyres in the search for shares that may be misunderstood or hidden from view, the smaller end of the market is a lucrative hunting ground for opportunities that others are missing.

Quality stocks at cheap prices have an obvious appeal to investors and unsurprisingly there are plenty of well-known investing strategies devoted to finding them. But as Ed wrote recently, one of the most famous strategies – Joel Greenblatt’s Magic Formula – has recently been called into question by researchers Dr Wesley Gray and Tobias Carlisle in their book Quantitative Value. Greenblatt, a successful hedge fund manager, introduced the Magic Formula in his 2005 book The Little Book That Beats the Market and investors quickly got hooked on its simplicity of ranking stocks based on two simple metrics (read more about that here).

The trouble with the Magic Formula is that while Greenblatt claimed a return of 30.8% every year for 17 years to 2004, very few others have been able to replicate, or even get near, that success rate with the same strategy. Gray and Carlisle suggest that part of the problem is that the Magic Formula systematically overpays for quality. In other words, taking a whole-of-market view and simply adding together the ranks for quality and value can actually land you with a pricey portfolio. Instead, they reckon it’s actually better to take the cheapest 20% of the market and then rank that set for quality.

Start with cheap… then look for quality

So how can you do it? Well, Stockopedia’s recent homepage facelift came with some handy new StockRank screening recipes that mean you can filter the market for companies that score highly on different rank combinations, including quality, value, momentum and growth. In this case, we looked to see which stocks were coming up on small cap quality and value screen, which looks for the cheapest 20% of shares with a market cap of between £50 and £350 million with the best relative quality credentials.

Under the bonnet, this screen ranks shares for cheapness based on six common value measures, scores them on each and then gives an overall composite rank of between 1 and 100. The same goes for quality, except here the ranking is based on a composite score using measures based on historic cashflow, profitability and margin stability (you can read more about StockRanks here).

What you get is a list of stocks that, based on their relative price and fundamentals, could be worth closer inspection. While many have seen their prices rise so far this year, some have been held back for various reasons while others come with big question marks. Chief among those, despite scoring exceptionally well as both a value and quality share, is education technology group, RM (LON:RM.) Its shares jumped in July (see chart below) on news that it was considering a special payout to shareholders and that profits in the first half of the year had increased. However, the company does have a pension deficit to deal with and has seen huge changes in its markets in recent years as new contracts under the PFI-funded Building Schools for the Future programme were scrapped. Paul Scott offers his views on RM here where he suggests it could be a ‘value trap’. Either way, all eyes are now on RM’s new CEO David Brooks to see if he can establish a stronger future for the group.

Also ranking highly on this list is Camellia (LON:CAM), a £250 million market cap conglomerate with a huge range of operations spanning agriculture, engineering, food storage and distribution and private banking and financial services. Employing 73,000 people worldwide, Camellia represents a substantial time challenge to any potential investor that wants to understand its businesses intimately. Shares in the company took a tumble during May and June, falling 19% to £80 (8000p) and have been slow to recover, potentially providing opportunity for contrarians.

Elsewhere, engineering and construction company Costain is another high achiever in the quality value stakes. Its shares have risen by 13% to 287p so far this year, which is rather modest against its FTSE Smallcap index. A possible reason for this is that Costain was outbid by rival Kier in April in the acquisition of May Gurney Integrated Services. The missed deal caused brokers to slash their EPS forecasts for next year (even though the consensus still rates it a ‘strong buy’). Net profits at the company grew last year by 29% to £24.2 million and it offered an upbeat assessment of the future following the challenging conditions in recent years.

Finally, Bloomsbury Publishing (LON:BMY) also ranks highly on this screen and has seen its share price rise by 20% this year to 139.7p. Sixteen years after publishing the first of all the books in JK Rowling’s Harry Potter series, Bloomsbury is these days focusing on making the transition from print to digital. Net profits in 2013 grew by a stunning 121% to £7.5 million and its forward yield now stands at 4.2%. But while independent publishers can often outmanoeuvre larger players (Rowling was apparently turned down by 12 publishers before finding Bloomsbury) there is little doubt that the industry is seeing huge change. With the emergence of powerful retailers like Amazon and mega-publishers such the newly merged Penguin / Random House, Bloomsbury undoubtedly finds itself in a rapidly evolving market.

Defensive quality at attractive prices

It’s clear that surging markets in 2013 have left investors short of options when it comes to value opportunities, particularly for good quality companies. With small-cap share prices proving to be major beneficiaries of the bullish conditions, there is a sense of inevitability in some quarters that some of these stocks will fall back to earth sooner rather than later. With that in mind, investors prepared to seek out the cheapest stocks with the best quality characteristics, could still find value opportunities with the strength to withstand market shocks.

To use Stockopedia’s powerful StockRanks to screen the market with the best (or worst) quality, value, momentum and growth ranks, why not take a free trial?

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