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A horde of smallcap stocks in almost every sector are sporting ratings that are low by every conceivable standard. Some obviously deserve these ratings, but many others don't. Elliott Davis reports

Stock market valuations, especially for smaller companies, have become increasingly realistic. Where it was once common to find companies sitting on p/e's of 100 times earnings, a rating of 15 can now look excessive. But in some cases the process seems to have gone too far, condemning a whole horde of firms to ratings so low that they have been thrust into the spotlight of bargain hunters everywhere.

All you have to do is work out which ones are, quite literally, as cheap as chips and which should be avoided at all costs.

Building from the

ground up

Any quest for value must begin with housebuilding and construction firms.

As a sector, construction currently boasts the lowest average p/e of any and it is therefore unsurprising to find a clutch of lowly rated smallcap gems hidden within its ranks.

Bett remains the pick of these, having produced strong results for the year to August (profits surged 70 per cent to £17.2 million). Market expectations for the current year are for a £19 million pre-tax profit and earnings of 91.4p, which, even though the shares have been steadily rising for some time, places Bett on a rating of only 4.9 times prospective earnings.

KBC Peel Hunt's Mike Foster is just one fan of the Scottish housebuilder. Aside from the lowly p/e, Foster points out that Bett is well backed by its net assets, valued at more than £62 million at year-end. He is also keen to highlight that because Bett bought the majority of the land it owns more than three years ago, it should still be able to generate decent profits even if house prices tumble.

In addition, Foster reckons that Bett's lack of exposure to London and the South East (it focuses instead on Cheshire, Newcastle and Scotland) affords it a mix of both defensive and growth qualities. Investors should note, however, that Bett has debts of £18.2 million.

Although it trades on an historic p/e of 6.4, Yorkshire-based housebuilder Ben Bailey also looks well worth snapping up.

Like Bett, its shares have performed well in recent times. July's interims were strong, with profits more than doubled to £2.2 million, driving earnings up from 6.81p to 14.92p, though turnover decreased slightly.

House broker Brown Shipley confidently predicts an even stronger second half with full year profits improving 132 per cent to £6.5 million and revenues climbing from £40.7 million to £49.8 million. If a recent bullish trading update (speaking of 'excellent' trading conditions and promising that full year figures will 'exceed market expectations') is anything to go by, Brown Shipley's faith in the company looks well founded.

Based on the forecasts of analyst Craig Cowen, the shares are valued at just 3.9 times 2002 earnings, dropping to 3.2 times 2003 forecasts. In addition, the shares are expected to yield a dividend of nearly 4.7 per cent.

Although Bett and Ben Bailey are the shine-out stars, three more construction firms are worth considering.

Despite £5.5 million of bad debt arising from work on Leicester City's new football stadium, building and civil engineering business Birse boasts a strong order book and looks an interesting long-term recovery punt. Countryside Properties has fairly high debt levels but covers these with a strong net asset position. Finally, cash rich McCarthy & Stone is widely tipped to prosper thanks to its focus on the retirement property market.

Retail bargains

An array of intriguing low p/e stocks can be found on the high street and in retail parks — and despite fears of an imminent collapse in consumer spending, a few retail players deserve much immediate attention.

Furnishings and household textiles business Homestyle (operator of retail chains Harveys and Rosebys), in particular, seems to be perennially under-valued by the market.

Despite producing an improved £17.5 million pre-tax profit from £601.4 million of sales in the year to 2002 and yielding a staggering 12.8 per cent dividend, Homestyle trades off of an historic p/e of only four times.

The reason for the company's low rating, as Matthew McEachran from broker Investec explains, is that it 'has suffered from a number of setbacks of late', most recently a retrospective £23 million VAT claim from HM Customs & Excise. Factor in debts of £104 million at the half-year stage and it is easy to see why the shares languish.

Yet, as McEachran points out, 'the actual business has performed fairly well throughout' — he expects a £36 million profit this year — and once the VAT issue is resolved, the shares look destined to receive a re-rating.

Women's occasion-wear designer and retailer Jacques Vert also warrants attention. The shares sit on an historic p/e of 2.6. And though this is expected to rise to 17 times earnings in the year to April (as Vert feels the effects of its recent £17.8 million acquisition of loss-making rival William Baird), longer-term, its prospects seem bright.

Vert's management team has already proven its worth, moving the then-troubled company from Full List to Aim in August 2001 and staging a near instant return to profitability. By April 2004, house broker Seymour Pierce predicts a turnaround in the William Baird business, too.

Seymour Pierce forecasts a profit of £7 million pre-tax and 3.9p of earnings for the period. Should Vert achieve this, its p/e rating would drop to a bargain basement 2.2 times.

Though slightly more expensive — trading on historic p/e's of 6.7 times and 8.1 times respectively — Alexon (owner of a plethora of well known high street stores including Bay Trading, Dolcis and Envy) and budget retailer Peacock also seem sorely undervalued.

Both issued positive Christmas trading statements and are expected to significantly grow profits and earnings over the next two years — dropping their future ratings to around five times.

Of the two, Numis analyst Ian McDonald favours Alexon. 'It's in a slightly better position and is highly cash generative,' he explains.

Leisure gambles

Those of a more speculative nature are likely to be drawn to the leisure sector, where a raft of pub, bar and nightclub operators are in the doldrums.

This is primarily due to the recent problems experienced by Old Monk (now in administration), SFI (serious accounting irregularities) and others, which have cast a dark shadow over pub chains either operating in the high street or focusing on the South East and London markets.

KBC analyst Paul Hickman advises that, for the time being, these areas should be avoided unless 'there are compelling reasons to suggest that a company is oversold'.

Conceivably, such an argument could be made for Urbium, operator of the trendy Tiger Tiger bar chain. In early January, the Aim-listed firm published a bullish Christmas trading update, highlighting 'a strong sales performance' throughout December and like-for-like sales up 3.4 per cent on the previous year.

Analysts now estimate that the company, which despite its West-End focus, also operates bars in Birmingham, Glasgow and Newcastle, generated a £8.8 million profit before goodwill and exceptionals for the year to December 2002. This would mark a £1 million improvement on 2001 and forecast earnings of 1.1p placing the shares on a forward p/e of five.

Yet, despite plans for further expansion in 2003, the trading outlook is uncertain. A profit in the region of £11 million is currently expected, though many analysts hint that they are likely to reduce their expectations following Urbium's next update.

Debts of close to £21 million are another concern. Nonetheless, at its current level Urbium has the potential to reward gamblers.

Having seen its share price bomb more than 60 per cent in the past six months, Luminar (see page 6) also looks cheap at present. Last year, the company generated earnings of 61.5p per share, affording it an historic p/e of 4.4 and, despite a January profit warning, earnings of 57.4 are predicted for the 12 months to February 2003.

The likes of Hickman and Arbuthnot's Alan Millar feel that those looking for a safe haven in the pub sector could do much worse than seek out Punch Taverns.

Though Punch is much larger than both Urbium and Luminar (it is currently valued at £420 million) its shares also trade at a discount to the sector. Forecast 2003 earnings of 35.9p place the shares on a prospective p/e of 4-4.7 times.

sectors to avoid —

software & sport

Given the prolonged periods of loathing which followed the high-tech boom and bust, it should come as little surprise that the software sector is also home to a raft of companies trading on what appear to be ridiculously low valuations.

However, perhaps more than any other sector, software firms illustrate the potential dangers of backing firms purely on account of a low p/e.

Take IT consultancy Marlborough Stirling for instance. Though it remains fairly well regarded by those taking a longer-term view, most analysts see little upside in the shares over the next few years. WestLB Panmure's Simon Strong, for instance, opines that the stock is 'not going to go anywhere for some time'. Arbuthnot's James Mitchell echoes these sentiments, adding that 'we have put out some fairly major downgrades going forward'.

IDS serves investors an even more important lesson. Take a leaf through the Financial Times and you will discover that the leasing software supplier trades on a historic p/e of just 1.3.

But things are not as they seem. Dig deeper and you will discover that this figure is calculated using an earnings figure excluding both goodwill and exceptional items. Factor both back in and IDS actually lost nearly 32p a share last year.

Meanwhile, sports management and marketing agencies are seeing sentiment harden against them in a similar way that it did against tech stocks two years ago.

CSS Stellar, First Artist, Proactive Sports and Sports Resource all currently trade on historic p/e's significantly below five.

This is primarily down to a stream of profit warnings within the sector and lingering concerns over the future of the football industry in the UK and Europe.

First Artist and Proactive have already warned since the turn of the year — blaming changes to the player transfer market. Sports Resource recently withdrew from football altogether and though CSS' interests are more diverse, it too appears to be struggling. Avoiding this sub-sector altogether appears the best course of action for now.