10 small-cap growth shares at cheap prices

Small-cap shares have been some of the hardest hit during the market sell-off, but this speculative part of the market could be where you’ll find the early winners in a recovery.

UK indices are home to shares in about 1,500 companies, and just over a third of them are small-caps. Precise definitions vary, but size-wise they tend to have market values ranging between £30 million and £500 million.

For both companies and their investors, it’s an area of the market with a history of both wild successes and some bitter disappointments. Some small-caps go on to become multi-billion-pound winners, while others fall by the wayside.

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Jim Slater, the revered City dealmaker and growth stock picker, once wrote the famous phrase “elephants don’t gallop”. It illustrated his view that larger stocks were far less likely than small-caps to deliver the huge re-ratings that investors like him were looking for.

He wasn’t the only one. Interest in small-caps is popular because successful stock picks in this territory can deliver life-changing returns.

Small-caps rarely attract the same extensive broker coverage that large-caps do. That’s because they are often too small for institutional investors to buy meaningful stakes in. This can create an information advantage for those prepared to roll up their sleeves and dig out the gems.

It’s an area of the market where companies tend to be early in the growth cycle. It’s a phase where revenues can grow quickly and business models start to mature.

This growth can be attractive in bullish periods - which is exactly what we saw at times in the years after the financial crisis, and particularly post-pandemic. Confident investors become willing to pay up for shares in firms where real profits may only start to flow years down the line.

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But as we saw through 2022, a painful mix of rising inflation, higher interest rates and the threat of recession was a triple whammy for smaller, speculative growth stocks.

For a start, rising inflation suddenly made it harder than normal to value their future cash flows. Growth stocks fell out of favour as investors raced to the arms of larger shares with well understood current cash flows and more modest valuations.

In turn, borrowing money became more expensive, as did the cost of raising equity via share placings. This rising cost of capital meant that growth firms potentially faced having to restrict themselves and their development plans. And that was the opposite of what growth investors really look for.

So after a decade and more of bullish conditions and surging demand for small-cap growth shares, they are now a much more contrarian option.

This year, the Numis Smaller Companies Index (including AIM but excluding investment trusts), which is a popular small-cap benchmark, has been flat. It has seen a positive return in 2023 of just 1.6%.

But while markets continue to watch for signs of improvement, research shows that small-caps can often deliver some of the early winners when a recovery in sentiment arrives.

Screening for small-cap growth at cheap prices

With many expecting the current rate-raising cycle to be nearing an end, last year’s poor show from smaller stocks could give way to a much improved performance. So what should you look for?

This week I have used three key measures to find shares that might be worth further investigations. They include:

#1. Valuation - Is the forecast price-to-earning (PE) ratio lower than the share’s average PE ratio over the past five years? This is a first-pass rule that aims to find shares that appear to be cheaper than they have been in the recent past.

#2. Earnings growth - Has the company got a track record of annualised earnings per share (EPS) growth over the past five years? And are the company’s earnings forecast to grow in the year ahead? The list is sorted by forecast earnings growth.

#3. Efficient profitability - Quality can be measured in a variety of ways, but a double-digit return on capital employed (ROCE) on average over five years is a simple rule of thumb that can help to pinpoint firms with good quality profitability over time.

Here are some of the shares that these rules pick up, including how they have performed relative to the FTSE All-Share index over the past 12 months:

At first sight, this screening approach produces a diverse set of shares to explore. Atalaya Mining (LSE:ATYM), the small copper/silver mining company, leads the list because it is forecast to see earnings more than double in 2023. But with a forecast PE of just 8x, it’s clear the market is still wary.

Financials are a theme, with consumer credit and pawnbroking firms H&T Group (LSE:HAT) and Ramsdens Holdings (LSE:RFX) both appearing. Ramsdens has a slightly stronger earnings growth history, but H&T has the stronger growth outlook. Both are on single figure PEs despite the fact that both have seen the shares perform well over the past year.

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Currency and asset management specialist Record (LSE:REC) and steel maker Billington Holdings (LSE:BILN) both have strong earnings forecast outlooks set against much more modest five-year averages, so that suggests there is more to investigate. Again, shares in those firms have some positive one-year momentum behind them.

Note the worst one-year momentum is in shares in Gem Diamonds (LSE:GEMD) and Integrated Diagnostics Holdings (LSE:IDHC), where -60% drawdowns are a reminder of just how hard the past year has been on some small-caps. 

Contrarian ideas in UK small-caps

Small-cap shares were among the biggest winners as markets recovered from the effects of the Covid pandemic. But with the inflationary pressures that followed, those shares found themselves well out of favour last year.

With the outlook perhaps even more uncertain than normal, and markets still prone to setbacks and possible recession, small-caps are likely to remain contrarian territory for a while. But in this relatively speculative area of the market, some companies have continued to grow their earnings, and some shares have performed well. It could be worth digging around for those that will get a boost when confidence starts to recover.

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