5 easy rules to find good small-cap stocks
This week I want to return to my back-to-basics theme, with a look at a simple set of rules that might be used to help find good small-cap stocks. The smaller end of the stock market can be a fertile hunting ground for growth stocks and potential multibaggers, as Ed discussed in his recent webinar and masterclasses.
(In the previous instalment of this mini-series, I created a simple screen to help find good dividend stocks – you can find that here.)
It’s easy to build more complicated screens with lots of rules – and that’s something I quite like to do. But I’ve often found that after a while, there can sometimes be a certain amount of overlap and redundancy between rules.
Screens can also become too exclusive, as good companies don’t necessarily fit an exact financial profile.
On a related note, it’s worth remembering that screen results are always best used as a tool to narrow down the market and provide ideas for further research. With this in mind, I think there’s some value in trying to distil what we’re looking for to its simplest form.
Given the historical success rate of the StockRanks, I also think it makes sense to leverage this powerful tool when building a screen. That’s what I’ve done here.
Here’s a snapshot of the rules I’ve created and a look at some of the shares highlighted by the screen.
My easy small-cap screen
The idea was to create enough rules to capture some essential qualities, without including anything unnecessary.
In this case, I asked myself what the absolute minimum criteria would be that I’d associate with a good small-cap stock. I’m not looking for outliers here, such as turnarounds or special situations. What I want are profitable, growing businesses, without too many complications or obvious risks.
Here’s what I decided:
Market cap: the definition of a small cap tends to vary, depending on who you ask. In US markets, small caps also tend to be larger than in the UK.
I’ve chosen a range of £25m - £750m because I think this covers a range that has historically been rich with opportunity, without being too speculative. Companies in this size range are small enough to multibag, but should also be reasonably well established.
StockRank: in Ed’s multibagger research, he looked at the top 10 performers over the last decade (2013-2023). The lowest StockRank any of the shares had at the start of the study period was 58.
I’ve chosen a minimum StockRank of 60, because I like the simplicity of round numbers.
Sales CAGR 3y: companies that can’t generate sales growth reliably (especially when inflation is high) may be facing external headwinds or have company-specific problems.
I’ve specified a minimum 5% compound average growth rate over the last three years.
Earnings per share CAGR 3y: as Ed explained in the multibagger webinar, operating leverage or margin expansion can be a powerful driver of share price growth.
Conversely, companies with falling profit margins can see their shares de-rated sharply to reflect their weakening earning power.
In a bid to avoid being too restrictive. I’ve specified a three-year compound average growth rate for earnings of 5%, the same as the sales growth rate.
In effect, this means that a company’s net profit margin must have been stable over the last three years for it to qualify for the screen.
Net debt to equity (net gearing): debt problems are always bad news for shareholders. Even if borrowing levels remain supportable, too much debt can limit companies’ ability to invest in their operations or fund shareholder returns such as dividends.
In my experience, the best companies are generally able to grow without relying too heavily on debt. This is a finding that was echoed by the multibagger research, which showed many top performers began their growth runs with net cash positions or minimal debt.
For this screen, I’ve specified a maximum net debt to equity ratio of 25%, meaning that net debt cannot account for more than 25% of the net asset value of a company.
Here’s how the finished screen looks:
You can see (and copy) my simple small-cap screen here.
Screen results
At the time of writing this screen returns 58 results. That’s a few more than I usually aim for, but investment opportunities among smaller companies can vary widely. I think it’s important to start with a reasonably broad selection and then narrow them down through further research.
Many of the names in this list will be familiar to regular readers of the Small Cap Value Report. I think there are some interesting names here, and certainly some potential opportunities:
Thoughts and next steps
I did wonder if the results of this screen would be heavily weighted towards one or two sectors. But it doesn’t seem to be that way. The results cover a broad mix of businesses from pretty much all areas of the market.
It would be easy to tweak the screen to exclude any sectors that aren’t of interest to me, such as mining shares, but for now I’ve left the results whole.
Looking down the list, I can see a number of shares I’ve written about in these pages in recent months, often as part of different screening processes.
For example:
Good Energy (LON:GOOD) - discussed here
SThree (LON:STEM) , Somero Enterprises (LON:SOM) , Record (LON:REC) and Keystone Law (LON:KEYS) - discussed here
Michelmersh Brick Holdings (LON:MBH) , Fonix Mobile (LON:FNX) and Capital (LON:CAPD) - discussed here
Oxford Metrics (LON:OMG) and James Latham (LON:LTHM) - discussed here
In addition to this, I currently hold Bloomsbury Publishing (LON:BMY) and Property Franchise (LON:TPFG) in my rules-based SIF folio and also hold Somero Enterprises (LON:SOM) personally.
Perhaps more than usual, I think this screen provides plenty of interesting starting points for further investigation. There’s a nice mix of growth stocks and more mature dividend payers, plus some family firms and a few more unusual businesses, such as FIH (LON:FIH) .
Many of the shares in these results have been covered in the SCVR. You can find these reports easily by clicking on the Discussion tab on the relevant StockReport.
Of course, there’s no substitute for doing your own research, especially at the smaller end of the market – but the collective wisdom of the community here at Stockopedia can be a good starting point for further investigation.
Disclosure: at the time of publication, Roland owned shares in Bloomsbury Publishing, Property Franchise Group and Somero Enterprises.
Disclaimer
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6 comments
Really interesting article, thanks Roland! I recognise lots of your screen's results from the SCVR, as you say. The screening tool is so useful, but it definitely helps give me ideas, to see the method and parameters used by you, and others. So setting out an example screen like you've done above is really helpful.
Thanks Roland
Strong sales growth is the leading indicator of future profitability. This is because strong sales growth often lead to operating margins expansion as companies gain leverage against their fixed costs, and in turn boost operating income growth and multiple rating.
There are five different ways companies can boost their sales growth: 1) selling more in existing markets due to more efficient markets, 2)increase prices, 3) new products introduction , 4) new market expansion and 5) acquisitions . These can act as catalysts for stock price appreciations.
In general, stocks should trade in line or a modest premium to their growth rates. For example, a stock expected to grow at 20% should trade at 20x forward P/E multiple to as high as 40x forward P/E multiple. The key question is whether its total addressable market, quality of its products or services and management team can support that level of growth going forward.
Stocks trading at a discount to their growth rates are excellent long-term investments. This is because the low multiples give them greater scope for multiple re-rating if their profits can grow at a respected rate. Meanwhile, this should limit the risk of multiple compression if their profits do go into reversal.
Stocks with minimal profits will have high P/E and this make them look expensive. The key questions to ask are: 1) Are their current profits being material depressed by major investments? 2) Is there a reason to believe that its long-term operating margin can be substantially higher than current level? and 3) Can its strong sales growth be sustained over a long-time? If the answer to all these questions are positive, they can still be good long-term investments with higher valuation risk if their profits don't grow as fast as the market expected.
In short, look for stocks that are generating strong sales driven by successful execution of growth initiatives and where there is potential for operating margin expansions. Meanwhile, buying them when they are trading at a discount to their growth rates reduces valuation risk and provides greater scope for multiple rating. This is a triple positive whammy effect (Sales growth x operating margins expansion x multiple re-ratings).
The ethos of this site is DYOR - a few articles explaining what this means for different writers might be interesting, especially for firms/sectors ordinary investors wont know ie not consumer facing stocks but obscure industrials for instance
As a lower league investor on Stockopedia, noting many smarter ones on these forums, I'm delighted to have have 7 on your interesting list Roland plus several more I intend to add. Thank you.
Interesting list - as Roland says some familiar names. I've added a rolling 1 yr P/E <16 to reinforce the value element and ended up with a list of 38.