After a tough year for a fledgling company, an equity screening expert Ben Hobson Identify which stocks may be at the forefront of recovery.
Last year was a difficult year for UK small-cap investors. Rising inflation and a series of rate hikes go hand in hand with declining valuations in major small-cap indices.
These economic impacts of higher interest rates, including lower consumer spending, slower growth, a possible recession, and risk-off sentiment, hit small-cap stocks the hardest.
But will that change soon? If so, where can you find small-cap stocks that are already showing signs of bucking the trend?
Prediction of Pivots by Central Banks
A look at some of the projections released by investment banks and commentators this year reveals some clear themes.
One is the feeling that inflation will ease in 2023. We already know that energy prices, which were the main driver of inflation last year, are now falling. How bumpy it gets from here remains to be seen, but the signs so far are encouraging.
This is important given how last year’s rate hikes (intended to curb inflation) affected small-cap valuations.
The FTSE Small Cap Index (excluding mutual funds), comprised of fully listed stocks outside of the market’s largest 350 companies, is down 19.8% in 2022.
The AIM 100 Index, which has a median market capitalization roughly in line with the Small Cap Index (just under £300m), is down 33.6%.
The chart below shows how the Bank of England’s string of rate hikes last year correlated with the fall in the FTSE Small Cap Index.
Bank rates rise in 2022 compared to FTSE Small Cap Index
It’s worth remembering that the market knew rate hikes were coming and was always trying to predict the magnitude and frequency of those moves. The relentless hike in interest rates caused the index to fall over time.
If inflation starts to ease soon, the market is likely to show signs of a turnaround in the Bank of England’s strategy. That could give small-cap stocks a breath of fresh air.
This brings us to the second main theme of recent market commentary. The UK market, especially small caps, looks significantly cheaper than many other countries. That doesn’t mean small-cap stocks won’t drop further, but it’s a big plus for those who have been wary of bubbled valuations in recent years.
As always, timing the market is nearly impossible. An additional challenge in such circumstances is determining how a potential recession will affect corporate earnings. This uncertainty makes accurate valuations and earnings forecasts even more difficult than usual.
Find cheap small caps on the move
Momentum is one of the factors that will help us in looking for an early recovery for small caps this year. Over the past year, many small-cap price trends have been negative, but some have resisted. Therefore, finding stocks with strong prices in the medium and short term can be a useful clue.
That said, momentum can be a dangerous tool in volatile times when the economic outlook is uncertain. So it makes sense to combine it with a focus on “bargain” (if stock prices may be recovering) or financial strength (if the market is moving up towards higher quality companies). I’m here.
With that in mind, this week’s screen focuses on companies listed on the FTSE Small Cap and AIM 100 indices. Here, companies are smaller, but generally more financially stable than speculative microcaps.
This is a sweet spot for retail investors, as stocks here can revalue much faster than stocks in big companies. Institutional investors tend to be less investigative as they can have a hard time dealing with the size of these companies’ stocks. Again, this gives the individual investor an edge.
Screening Techniques to Determine Momentum
A common technical approach to finding moving stocks is to look for stocks where the 50-day moving average price is ahead of the 200-day moving average price. This is known as the “Golden Cross”.
Moving averages (such as the 50-day moving average line) work by cutting out noisy daily price movements that can mask the underlying price trend. Anything above 100% in this “Golden Cross” measurement suggests that short-term price momentum is accelerating, which can be a positive sign.
On this screen,
- The 50-day moving average has broken above the 200-day moving average.
- Price strength was positive for the market over 1 year, 3 months and 1 month
- Positive earnings per share growth forecast for the full year
Data: Stokopedia
Unsurprisingly, this momentum-driven strategy has seen some of the best performers of the past year, including self-service vending machine business ME Group International (LSE:MEGP) and customer relationship systems specialist Cerillion (LSE:CER). We are picking up small-cap stocks. Both companies have beaten earnings expectations over the past year, which is reflected in the stock momentum.
Others include Hunting for Energy Services Group (LSE:HTG). It’s set to turn a solid profit in a year from losses, and is engineering consultant Ricardo (LSE:RCDO). Also, several of these stocks have single-digit price/earnings ratios (p/e), such as Card Factory (LSE:CARD), Capital Ltd (LSE:CAPD), CentralNic Group (LSE:CNIC), and Ten. Please be careful. Entertainment Group (LSE:TEG).
The only exception to the rules in this table is Zotefoams (LSE:ZTF), a specialist foam manufacturer. Technically, it fails because the year-long relative price strength is below the market. But it passed on a 3-month and 1-month basis, and its price shows technical signs of accelerating, and earnings-per-share (EPS) growth forecasts he’s also solid at nearly 20%. is. This is an example of how his negative one-year performance is giving way to more positive signals in the near future that may prompt further investigation.
Overall, small caps have been in trouble over the past year, with rising interest rates casting a heavy shadow over the economic outlook for the market’s smaller companies. Despite the headwinds, some companies in the region are still performing solidly and appear able to withstand further pressure.
Careful research is essential in this part of the market. And mixing good value with quality-focused momentum is worth considering. It seems likely that an improvement in economic conditions will provoke renewed interest in them.
Ben Hobson I am a freelance contributor and not a direct employee of Interactive Investor.
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