Finding undervalued small-cap stocks isn't easy in today's strong market conditions. But I've identified two which I think could deliver significant gains for investors.
The first of these is data analytics software group Oxford Metrics (LSE: OMG). The firm's shares rose by 7% on Thursday, after it announced that adjusted pre-tax profit for the year ended 30 September is expected to be "slightly ahead of market expectations".
Broker forecasts previously were for earnings of 2.3p per share for the year. In my view, the wording of Thursday's update suggests that the final figure could be 5%-10% higher than this -- perhaps 2.4p-2.5p.
That would still leave the shares looking fairly pricey, on around 25 times forecast earnings. But the company is expected to deliver substantial further gains in 2018. Recent forecasts suggest that earnings per share could rise by as much as 50% to 3.5p next year. That would give the shares a more reasonable P/E of 18.
Just another expensive tech stock?
Valuations for some tech stocks have become pretty steep in recent months. But in my view, Oxford Metrics' fundamental quality suggests its valuation might be justified.
The first point to note is that it's highly profitable and generates plenty of cash. The group's operating margin was 18% last year, while return on capital employed (ROCE) -- a key measure of profitability -- was about 16%. Both figures are well above average.
Today's trading update also suggests that Oxford Metrics has continued to generate strong free cash flow this year. Net cash for the year just ended was £9.8m, up from £8.3m the previous year.
High profitability and strong cash generation provide good support for the group's dividend. This payout has grown by an average of 27% since 2011, and now offers a forecast yield of 1.7%. I plan to continue holding my shares following today's gains.
A high-yield alternative
If you're looking for small-cap stocks with a high dividend yield, you might want to consider spread-betting and stockbroking firm CMC Markets (LSE: CMCX). Its shares halved in value last year, when the FSA announced plans to limit the amount of leverage that could be offered to retail customers.
We don't yet know what form these new rules will take. But in its latest trading statement, CMC emphasised its focus "high-value, experienced clients", whose activity may be less affected by any changes to the rules. The group is also continuing its expansion into stockbroking through a partnership with one of Australia's largest banks.
According to a recent trading statement, half-year profits are expected to be "significantly higher" than for the same period last year. The market has certainly regained its confidence in the business, as the shares have now risen by more than 50% from last year's lows.
Is this view correct? It's too soon to say. In the firm's H1 trading statement, management warned that it "remains cautious about the future outlook given the ongoing regulatory uncertainty".
However, the shares now trade on a 2017/18 forecast P/E of 12.5, with a prospective yield of 4.5%. In my view this is probably cheap enough to discount the risk from regulatory changes. I'd continue to hold.
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Roland Head owns shares of Oxford Metrics. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.