10 cheap small-cap shares ripe for recovery

Stock screen expert Ben Hobson applies a ‘small-cap value’ strategy inspired by star investor James O’Shaughnessy to highlight smaller company shares that could be future winners.  

There was a moment last October when investors in small-cap shares would have been forgiven for wondering just how bad things were going to get.

Bearish sentiment had dragged on prices all year. Shares in smaller companies were the biggest losers. After a phenomenal run in the Covid recovery of 2020 and 2021, many saw those gains wiped out.

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The Numis Smaller Companies plus AIM Index, a major small-cap benchmark, fell by 21.9%. But could things be looking up from here?

If the history of recessions and recoveries is anything to go by, small-caps could now be poised for an upturn.

This week, I’m going to explore ways of playing that theme with a ‘small-cap value’ strategy inspired by one of the most influential investors of the modern era: James O’Shaughnessy (pictured further down this article).

How to handle sensitive small-caps

There were several reasons why small and large-cap stocks experienced such differing fortunes last year.

For a start, sectors played an influential role. Many of the largest shares are found in defensive industries that protect them from weakness in the economy. Sectors such as health, consumer staples, utilities, energy and finance all proved to be a good place to be.

Many large-caps also have sprawling businesses with sales in foreign markets. For them, a strong US dollar last year translated into a meaningful boost to profits, and that protected them.

By contrast, smaller shares are much more sensitive to the economic outlook. They are often too small to have the benefits of scale, foreign exposure or financial resilience.

That kind of sensitivity is why recession has historically spelled bad news for small-caps - and why they performed so badly in 2022.

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In recent commentary, Mark Niznik, who co-runs the UK smaller companies strategy at Artemis, pointed to the fact that small-caps have underperformed in five of the past eight recessions since the 1950s. And last year they did worse than they had in any of those previous downturns.

But the good news is that in seven of the past eight recessions, small-caps outperformed by an average of 8% the following year.

So you could argue that a recession (should one arrive) has now been priced in and that small-caps could be well placed to stage a recovery.

That ability to bounce back quickly rings true when you consider the longer-term performance of smaller stocks, which have historically outperformed large-caps. Since the inception of the Numis Smaller Companies Index in 1987, smaller companies have beaten FTSE 100 blue-chips by 3.1% a year on average.

A strategy to find cheap small-caps on the move

One man for whom this kind of punchy small-cap performance has never been lost is the now-retired US fund manager, James O’Shaughnessy (pictured below with wife Melissa).

He spent a good part of his early career studying the quantitative traits of stocks that outperform. He famously once said: “You’ll get nowhere buying stocks just because they have a great story.”

One of O’Shaughnessy’s successful approaches combined a focus on relatively small, cheaply-priced shares with positive earnings and strong price momentum behind them.

It was a simple growth-value-momentum strategy using a handful of basic measures, but it was a strong performer. Here are the basic parameters:

• Market capitalisation between £25 million and £500 million (small size)
• Price to Sales of less than 1.5x (cheap value)
• Five years or more of earnings growth (growth)
• Positive share price strength (relative to the market) over six months and three months (positive momentum)

O’Shaughnessy’s original size rules looked for shares with a market cap of more than $150 million. Here in the UK, the definition of small-caps is smaller than in the US, so this strategy sets the minimum at £25 million.

In terms of value, O’Shaughnessy initially opted for Price-to-Sales (PS) as his favoured ratio - with the share price trading at less than 1.5x sales-per-share. Later on he switched to a composite approach - ranking stocks based on several value measures. But for our purposes, PS is a useful value proxy and easy to use.

When it comes to consecutive years of earnings growth, Covid and the chance of recession have made life hard for smaller companies. So I’m slackening O'Shaughnessy's rule for a string of five years of earnings per share (EPS) growth and instead I’m looking for positive EPS growth over five years, which allows for the occasional down year.

Finally, the momentum rules are simple. I’m looking for shares prices that are positive relative to the performance of the FTSE All-Share index over six months and three months. That’s a tough ask in this environment, so any small-cap share that can pass it ought to be worth a second look.

Here are some of the shares that these rules pick up:

Source: SharePad

Like all small-cap value screens, this is unlikely to be a list of shares to rush out and buy - but more a starting point for further investigation. While the screen rules set a minimum market cap of £25 million, the lowest currently is £63.1 million at building products firm Alumasc (LSE:ALU), and the largest is £225.4 million at lighting specialist Luceco (LSE:LUCE).

In terms of earnings growth, Malaysian cement maker Steppe Cement Ltd (LSE:STCM)’s swing from a loss over the past five years flatters its five-year growth average, but the improving profitability is eye-catching. Others like Luceco, auto retailer Vertu Motors (LSE:VTU), Ramsdens Holdings (LSE:RFX), and Xpediator (LSE:XPD) have all seen triple-digit profit growth in that time.

Valuation-wise, O’Shaughnessy’s preference for the Price-to-Sales ratio needs care when comparing businesses in different sectors. Some sectors have a tendency to low PS ratios, so I’ve included the price/earnings (PE) ratios for extra context. But all these shares appear cheap on both measures.

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In terms of price strength, several of these shares have been on a roller coaster over the past year. Luceco, the strongest stock on a six-month price strength basis, is actually down by 47% on a one-year basis. That gives you a sense of the scale of the price pressure that hit these small-caps last year. But the recent strength is promising.

Small-caps to keep an eye on

After a difficult year in 2022, there is an argument that small-caps could be the early winners as the market begins to look beyond recession. But the risks are high. Small-caps are volatile and prone to setbacks so care is needed.

I’ll be revisiting this strategy later this summer to see whether the promise of the ideas in it, and the stocks it detected, were what I might have hoped for. I expect a bumpy road ahead, but O’Shaughnessy’s common sense rules of focusing on growth, value and a positive trend give me confidence that it will be able to find winners.

Ben Hobson is a freelance contributor and not a direct employee of interactive investor.