10 quality small-cap shares with reliable profits

Small-cap shares have been among the worst-hit in 2022, so stock screen expert Ben Hobson has gone looking for those that have been oversold.

Shares in smaller companies have been hit hard over the past year, and nowhere is that more evident than on the Alternative Investment Market (AIM).

AIM is London’s junior market for growth-focused firms. It gives them the premium profile and access to capital that comes with a City listing (but with lighter-touch regulation). And for investors, AIM shares have both attractive tax benefits and punchy potential for big re-ratings if they do well.

But like all small-cap exchanges around the world over the past year, a gloomy outlook has caused bullish buyers to run for cover.

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The AIM All-Share index, which comprises over 760 companies, is down by 31% over the past 12 months. The more elite AIM 100, which tracks the market’s largest firms, is down by 33%. Those are pretty stark declines when you consider that the main FTSE All-Share is only down by 5%.

For students of the market, none of this will come as much of a surprise. Faced with rising inflation and interest rates and the threat of recession, small-caps were always likely to suffer. With less financial firepower to withstand shocks, their growth trajectories are much less predictable. In times of turmoil, they cease to hold the appeal they once did.

These problems are made worse by the fact that small-caps generally don’t have the same level of institutional backing enjoyed by larger stocks. It’s often impossible for big money managers to buy meaningful stakes in these firms (unlike private investors, who have smaller pots of cash to invest). So when markets turn jittery, the lack of solid support from stoic professional funds can make small-cap share prices all the more volatile. Some would even say scary.

Sizing up the small-cap effect

While all this seems pretty grim, it’s worth remembering that there is a general trend in stock markets over time for smaller stocks to perform better than larger ones. The ‘size’, or ‘small-cap’ effect was only proven in the early 1980s, but there’s now a general consensus that it really does drive returns.

One of the drivers of small-cap outperformance is that smaller firms tend to be in the early stages of the business growth cycle. If a firm is ever going to expand rapidly, it will most likely happen in these initial phases. So it makes sense that this is where investors like to look.

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Plus, while smaller companies can be susceptible to the economic climate, they can also be surprisingly quick to adapt. Just look at the months that followed the ‘Covid crash’ in March 2020. Back then, pandemic uncertainty caused shares to sell off across the board. But once confidence began to return, the AIM market flew out of the blocks. Small-cap shares led one of the most remarkable bull runs we’ve seen in years.

All eyes on resilient earnings

With AIM shares falling sharply over the past year, it’s clear that investors are worried by rising inflation. Higher costs for raw materials, energy and wages all affect businesses differently. They can eat away at profit margins if they can’t be passed on to customers quickly. Because of this, all eyes are on those firms with resilient earnings.

Earnings growth is commonly used in strategies that aim to find fast-moving small-cap shares. But in the search for earnings resilience, it could be worth taking a broader view of a company’s past, present and future earnings, as well as any surprises to the upside. That can provide a clearer picture of those that are holding up well - and may even re-rate as the economic outlook improves. Here are some of the variable to look for:

• Earnings per share (EPS) growth - did the company manage to grow its profits in its most recent financial results?

• Earnings surprise - did the company’s earnings beat analysts’ expectations last year?

• Five-year EPS growth - has the company been growing its earnings over the past five years?

• Forecast EPS growth - do analysts expect earnings to grow in the next two financial years?

This screen looks for positive results in each of these earnings measures and sorts them by the scale of the earnings surprise last year. It also includes the relative price strength of those shares over the past year - with some doing much better (and others doing much worse) than the market.

As you can see, there has been no shortage of earnings surprises recently, with profits coming in well ahead of forecasts at several firms. That includes earnings that came in at nearly 30% ahead at Cerillion (LSE:CER), the customer management systems specialist. There have also been double-digit ‘beats’ at scientific instruments group Judges Scientific (LSE:JDG) and metering firm Sureserve Group (LSE:SUR).

While Cerillion, Judges and web domain company CentralNic Group (LSE:CNIC)have seen some strength in their shares over the past year, the overwhelming picture here is of poor price performance. Most have been pegged back despite a solid history of earnings growth and expectations that will continue. For investors, the question is whether shares like these (and other) have been unfairly oversold - or whether reduced valuation are reasonable.

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Of course, earnings are only one way of looking at profitability - but as a starting point, examining recent results, medium term trends and expectations for the future might give you clues about how a business has been performing, and how it might continue to perform in the face of tougher economic conditions.

Set against its share price performance, earnings resilience might also give you an idea about whether a stock has perhaps been unfairly swept up in the sell-off - or deserves to have been marked down.

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