Interactive Investor

10 quality AIM small-caps that are resisting market fears

26th October 2022 13:37

by Ben Hobson from interactive investor

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For small-cap investors, 2022 has been a torrid year, but stock screen expert Ben Hobson highlights good quality shares that have fallen with the market but are showing signs of recovery.

Halloween pumpkin 600

There have been plenty of scares in the stock market this year, and with Halloween fast approaching spooked investors will be hoping the worst is soon over.

Nowhere has the terror of sliding prices been so keenly felt in 2022 than among UK small-cap shares - especially the Alternative Investment Market, which is down by 33%.

Some commentators now think that small-caps have sold off too far. But with economic fears still high, it’s a perilous part of the market.

One strategy that investors can use in these conditions is to look for good quality shares that have fallen with the market but are showing signs of recovery.

Blood on the streets…

It isn’t just UK small and micro-cap shares that have suffered from plummeting prices this year. There have been similar trends across Europe and the US.

In a number of territories central banks are raising interest rates to fight high and rising inflation. And with that comes the risk of recession, with some evidence that we’re already in one. Mix in high energy prices and the misery and disruption of war in Ukraine and it’s clear why investors are feeling wary.

Faced with these conditions, the market has gone ‘risk off’ small-caps because they are sensitive to economic headwinds.

That said, the UK market does seem to have had a particularly bad experience this year. Research by the analysis firm FTSE Russell shows that, of all the factors that drive investment returns in the market, the ‘size effect’ (the tendency for small-caps to outperform) completely collapsed in the UK between July and September.

Small-caps also underperformed in Europe during the third quarter, but the size factor was actually a positive contributor in the US.

Where now for small-cap prices?

Some good news for investors is that price pressure could well mean that small-cap shares now enjoy cheaper valuations. However, it’s hard to know exactly how economic turmoil will affect earnings forecasts - and that makes it even harder than normal to reach accurate valuations with measures such as the price-to-earnings ratio.

But as and when the outlook improves it is reasonable to think the market might start to price in a recovery quite quickly. The bad news is that there could be worse to come before that happens. Either way, it makes sense to look for those shares that are already seeing improved momentum.

If you are looking for inspiration, there are a few investment legends with strategies for these kinds of conditions.

David Dreman, the value-focused fund manager, is an arch-contrarian with several approaches to finding beaten-down shares. He combines value measures such as the price-to-earnings ratio with factors such as earnings growth and quality measures like low debt and good profit margins.

By comparison, one of the early strategies devised by quantitative money manager James O’Shaughnessy, combines small-caps that are cheap on a price-to-sales basis and have strong one-year momentum in their shares.

O’Shaughnessy’s approach echoes a value and momentum strategy developed by another academic-turned-fund manager called Josef Lakonishok. His preference is to use the price-to-earnings ratio and combine it with medium-term relative price strength and signs of improving earnings.

Upbeat signals to look for

With valuations still difficult, this screen takes a more focused look at small-cap shares on the Alternative Investment Market that have performed better than the index over both a six- and three-month basis. This is where we might find clues to shares that are resisting the market trend.

Taking the spirit of Dreman’s approach, it looks for companies where earnings grew last year and are expected to grow this year. Operating margins need to be in double-digits and these companies need to have no gearing. These measures can help pinpoint companies that are better able to withstand economic pressures.

Name

Market cap (£m)

P/E ratio

P/E 5y av.

Forecast EPS Growth %

Price relative to AIM (3m)

Sector

Warpaint London (LSE:W7L)

116.7

16.8

18.2

17.8

34.9

Personal Goods

Alpha FX Group (LSE:AFX)

854.5

32.2

34.9

15.9

33.2

Investment Services

Cerillion (LSE:CER)

355.3

39.5

22.9

19.3

27.2

Software and Computer

Ergomed (LSE:ERGO)

597.1

29.1

44.3

3.5

24.6

Pharma and Biotech

Enwell Energy (LSE:ENW)

79.2

1.3

10.5

49.7

24.2

Oil, Gas and Coal

EMIS Group (LSE:EMIS)

1,178.2

31.3

23.7

9.3

13.9

Software and Computer

Keywords Studios (LSE:KWS)

1,849.5

27.5

40.8

16

13.3

Leisure Goods

Franchise Brands (LSE:FRAN)

195.0

21.7

24.4

34.4

11.9

Consumer Services

Netcall (LSE:NET)

130.8

36.9

42.7

45

11.9

Software and Computer

Gamma Communications (LSE:GAMA)

1,049.9

15.2

26.7

12.8

11.3

Telecommunications

Among the results is healthcare software specialist EMIS Group (LSE:EMIS), which is in the process of being taken over. It’s an instructive example of how good quality shares may increasingly become attractive takeover targets, particularly for American buyers (as in this case) that have the benefit of the strong US dollar.

Other software shares making the list include Cerillion (LSE:CER) and Netcall (LSE:NET), but it’s a diversified group. Make-up firm Warpaint London (LSE:W7L) has underperformed its sector in recent years but strength against the index puts it at the top of the list. It suggests the market is sensing improvement at Warpaint and that is feeding into price momentum.

Overall, this list has a good quality feel to it, with earnings set to grow in the year ahead - and because of that the P/E ratios of the shares don’t immediately look cheap. However, Warpaint, Alpha FX Group (LSE:AFX), Ergomed (LSE:ERGO), Enwell Energy (LSE:ENW), Keywords Studios (LSE:KWS), Franchise Brands (LSE:FRAN), Netcall (LSE:NET) and Gamma Communications (LSE:GAMA) are all currently trading on P/E ratios below their five-year average.

For small-cap investors, 2022 has been a torrid year. But with index valuation down by 30% it’s hard to escape the feeling that some shares might have been unfairly caught up in the chaos as risk-averse investors ran for cover.

Economic pressures are likely to play havoc with earning forecasts for the time being and it could be a rocky ride as smaller companies navigate their way through multiple challenges. With that in mind, it’s important to do your research carefully.

But there are signs of optimism and share prices are responding in places. At this stage it looks like higher quality small-caps are capable of generating some momentum. In the search for opportunities, it could be early recoveries like these that accelerate when the economic outlook improves.

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

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