Enter top quality small caps

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AIM has risen by 50 per cent over the last 18 months, which means small-cap investors have had a strong following wind. But to have gained maximum benefit, we’ve have had to focus on the top-quality growth stocks within this universe. This isn’t always an easy thing to do.

On one hand it’s very easy to like good quality companies. They typically have strong balance sheets, consistent earnings, a high return on capital employed, and plenty of other desirable characteristics. However they often come at a high price, especially if their quality is allied to strong growth. High valuations are off-putting and present a hurdle that investors are having to overcome in this bull market.

Let’s put some numbers on this. Here are the prospective p/e ratios for a few of AIM’s leading stocks: ASOS 57, boohoo 52, Fevertree 54, Keywords Studios 40, First Derivatives 54.

The median stock valuation on AIM is 15 times earnings; so we are being asked to pay around three-to-four  times the market multiple to travel in the first class compartment. So far it’s been right to grit our teeth and pay this high entry price; but it’s also right to question how much further the trend can continue?

Two things need to be sustained. These beloved stocks have to keep generating upgrades to consensus expectations. They also need the low interest rates and bond yields, which support high p/e’s. Low yields mean that future earnings are discounted at a low rate, and are therefore more valuable – which is expressed in a high p/e ratio. If bond yields begin to rise, then the wind’s direction will change, and those future earnings would become less highly valued. We will need to keep this ‘big picture’ issue in mind when buying into those good quality stocks.

PCF Group (AIM: PCF) has released its first full-year results as a newly-constituted bank. The company has performed well during a period when management’s focus was on gaining the banking licence. As well as the necessary investment in infrastructure and systems for this, the company has also raised £10 million of new equity. This impacted near-term returns, but as CEO Scott Maybury says, management now have a clear run at delivering their target of £350 million in assets by 2020 and a 12.5 per cent return on equity.

The bank took £53 million of deposits between getting its licence in late July and the end of September. This lower cost of funds will enable it to enter the prime SME asset finance and consumer auto loan segments, which increases the addressable market by an order of magnitude. On a p/e of 9 for September 2019 and high-teens growth, the shares remain a buy.

Near-new car dealer Motorpoint (LON: MOTR) is firmly back on track after a wobble last year. UK new registrations might be down 5 per cent for the year and used sales flat; but Motorpoint is a niche retailer with a market share under 5 per cent, which enabled it to grow revenues 18 per cent in the half-year to September. Gross margins of 7.9 per cent have also been restored to normal levels.

The retail network now extends to 12 sites, with Motorpoint looking to add a new one each year. The company’s reach is also extended by a third of sales originating online. With limited capex needs and strong cash generation, a £10 million buy-back has been announced as well as a nice dividend uplift. The stock might have bounced nicely, but a prospective p/e of 11 and yield of 3 per cent still looks good value.

The post Enter top quality small caps appeared first on Growth Company Investor.



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