Interactive Investor

Stockwatch: are UK small-cap shares increasingly uninvestable?

2nd September 2022 12:09

Edmond Jackson from interactive investor

The current economic scenario feels worse today than the early 1970s, says companies analyst Edmond Jackson. Here’s his analysis of the impact on smaller companies and their prospects.

If the likelihood is an economic recession, then easing only to stagflation for the next two years, it is necessary to consider tactics regarding exposure to small-cap equities. 

Worst economic scenario in living memory 

Equity bulls say any whiff of a settlement over Ukraine, or concerted EU intervention in energy markets, will see gas prices slump and financial assets rise. I think Vladimir Putin is deeply dug into the war and will exact the most pain he can for Europe, turning off the gas. Meanwhile, Russian oil can be sold to China and India. Possibly, economic strains force some kind of capitulation by Russia eventually, albeit a long way off. 

The US is less exposed to high energy prices, having substantial oil and gas reserves, and is also well advanced in fracking. But the Federal Reserve’s overdue resolve to bring inflation down to 2% with higher interest rates – the only and blunt weapon it can bear – risks recession that spreads. 

I do not think it alarmist to say that the scenario feels worse today than the early 1970s. At least back then, prices of essential foods were fixed by law. Today, that would make production unviable.  

Smaller companies tend to fare relatively worse during recessions, lacking economies of scale, with their set-up meaning revenue changes get magnified at the profit level. There’s also a tighter market for their stocks, hence they react more dramatically. 

If you agree with me, difficult months if not years lie ahead, especially for UK small-cap shares serving the domestic economy, and it is necessary to review your portfolio exposure. 

This is not to put a “sell” stance on a sector that has mostly suffered a bear market for the past 12 months, but I think a judicious approach is vital. “Hold” after a big drop or resilient trading statement would seem fair, but there is no room for complacency. 

Barring over-sold trading situations in the short term, a long-term investing approach would await (more) profit warnings.  

For how long can discount retailers resist a recession? 

Three months ago, the giant B&M European Value Retail (LSE:BME) warned on profits as revenues were hit by higher living costs affecting its customers. 

The real increases lie ahead, hence small-caps dependent on consumer demand must be adeptly positioned, just to be viable. 

For now, Shoe Zone (LSE:SHOE), which sells low-priced footwear, has upgraded pre-tax profit expected for its year to 2 October, from a minimum £9.5 million to minimum £10.5 million. This follows ongoing strong demand for summer and back-to-school items plus margin improvements. 

In response last Wednesday, the stock rose from 145p to 158p, having already retreated from an 18-month high of 196p a month ago. It then dropped back to 145p but is energised this morning to over 170p in response to news of a £3.5 million buyback programme. 

The forward price/earnings (PE) ratio is over 15x assuming a consensus earnings per share (EPS) forecast of circa 11p in respect of the October 2023 year. A circa 6p dividend implies a 3.5% yield. 

Shoe Zone ought to enjoy some trading down from pricier rivals, but quite whether that will offset lower demand ahead is unclear. I cannot see impulse buying of footwear as sustainable.  

A high single-digit percent operating margin (see table) is expected to reach double digits this financial year, after good management of costs and the supply chain. There is at least some cushion. 

Shoe Zone - financial summary
Year-end 2 Oct

 201620172018201920202021
Turnover (£ million)160158161162123119
Operating profit (£m)10.49.811.46.9-12.711.0
Operating margin (%)6.56.27.14.2-10.49.2
Net profit (£m)8.57.99.55.7-11.97.0
Reported earnings/share (p)16.915.819.011.4-23.815.3
Normalised earnings/share (p)17.416.219.218.4-11.222.7
Operating cashflow/share (p)23.721.925.725.531.260.2
Capital expenditure/share (p)6.410.310.214.65.62.8
Free cashflow/share (p) 17.311.715.510.925.657.4
Dividend per share (p)10.110.211.53.50.00.0
Covered by earnings (x)1.71.61.73.30.00.0
Return on capital employed (%)23.024.424.515.6-19.019.3
Return on equity (%)25.025.927.416.4-54.342.7
Cash (£m)15.011.815.712.213.319.0
Net debt (£m)-15.0-11.8-15.7-12.251.128.4
Net assets (£m)29.831.238.431.412.423.4
Net assets per share (p)59.662.376.862.924.846.8

Source: historic company REFS and company accounts

Buybacks may limit downside risk and April’s balance sheet had nearly £14 million cash versus no debt. There were £38 million leases relative to £29 million net assets albeit generating a modest interim finance expense of £0.6 million. 

Yet I think small-cap boards should hold off buybacks, otherwise shareholder value will be lost as warnings proliferate during the next 12 months. 

Shoe Zone exemplifies a well-run small company enjoying a definite niche, whose equity will be worth buying in due course.  

The company floated in May 2014 at 160p, resulting in an £80 million market value and £36 million pay-out for family owners. The stock traded volatile-sideways from 130p to 230p, until Covid took it down to 36p by October 2020.  

I suggest vaccines and loose fiscal/monetary policy – now changing – were chiefly responsible for an apparent growth trend.  

My logic therefore weighs towards taking at least some profits and/or reducing risk, more towards “sell” at 170p than “hold”.   

Few businesses can escape pervasive cost increases 

Cream cake shop franchiser Cake Box Holdings (LSE:CBOX) warned last Wednesday of higher than anticipated inflationary cost pressures. 

Some of them – presumably cake ingredients – have been passed on to franchisees, and in due respect the table below shows operating margins averaging over 20%, hence an ability to withstand what also lies ahead. 

Cake Box Holdings - financial summary
Year-end 31 Mar

 2016201720182019202020212022
Turnover (£ million)5.68.712.816.918.721.933.0
Operating profit (£m)1.223.44.43.84.37.8
Operating margin (%)21.722.926.326.320.319.423.7
Net profit (£m)1.11.62.83.03.13.46.3
Reported earnings/share (p)2.74.16.97.57.78.415.8
Normalised earnings/share (p)2.74.16.98.77.79.414.2
Operating cashflow/share (p)5.41.58.07.98.310.813.2
Capital expenditure/share (p)1.41.01.35.33.11.82.8
Free cashflow/share (p) 4.0 0.56.72.55.29.010.4
Dividend per share (p)   3.61.65.60.0
Covered by earnings (x)   2.14.81.50.0
Return on capital employed (%)58.746.254.043.833.229.836.5
Return on equity (%)52611678.453.238.831.144.0
Cash (£m)0.20.52.53.13.75.56.9
Net debt (£m)1.52-0.9-0.9-2.1-4.0-2.6
Net assets (£m)0.42.44.76.69.512.216.5
Net assets per share (p)1.06.011.716.623.730.441.3

Source: historic company REFS and company accounts.

The warning still shocked the market, and showing how relative illiquidity can mean dramatic change, Cake Box plunged from around 180p to below 100p briefly in early trading. 

I drew attention to Cake Box as a “buy” from 163p in September 2018 having listed at 108p in June that year. Quite like Shoe Zone – in a macro sense – it was from late 2020 that a bull run got going for Cake Box, from 180p that November to over 400p a year later. 

In July 2021, I suggested the stock was getting over-cooked at 330p, hence why I said “lock in some gains” - within an overall “hold” stance - as bullish sentiment towards small-caps could change. 

It was impossible then to anticipate soaring energy prices as a result of the Ukraine war, impacting household disposable incomes. 

Cake Box shows how dramatic this can be for small-cap economics and stock prices.  

Its website shows boxes of six cupcakes from £11 and modest-size, eight-inch cakes from around £30. Will people continue to splash out like that? Prices will likely also need to rise to keep the franchises viable. 

Since this is egg-free cake (the company was founded originally to meet Hindu needs) it requires extra cream to offset dry sponge, which has generated mixed customer reviews. I think a limit exists for expanding this concept. 

Sales have been 2.8% easier so far in the first half to 30 September. Possibly the heatwave affected store sales, but management has guided down March 2023 profit expectations such that its broker now looks for a 24% drop at the pre-tax level to £5.5 million, and EPS of 10.9p. I suspect multiple cautions on revenue are possible over the next 12 months. 

The CEO has bought just over £274,000 worth of shares near 122p, taking his stake to 25%. He did, however, sell £10.5 million at 350p last November, plus almost £6.4 million at 170p in September 2020. 

Maybe that proves him a shrewd judge of value – and, indeed, buyers have appeared. Yet selling big chunks of small-cap equity may only be possible when the going is good, and his ongoing stake is an incentive to prop up confidence.  

Cannacord Genuity sold down a stake from 12.0% to 9.7% on 31 August – partly to the CEO? – maybe at a loss. 

The rebound continues to over 145p, but for macro reasons my overall stance is “sell”. 

Short-term traders may attempt to use big plunges in small-cap share prices to make a quick profit, but medium-term investors should rigorously appraise such holdings. 

Edmond Jackson is a freelance contributor and not a direct employee of interactive investor.

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