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The leading cash generative sector within the Top 50 this year with six companies proved to be support services. This was followed by oil and gas and software and computer services with five companies each.

In most cases, these companies’ position within the Top 50 is a reflection of an apparent “glass ceiling” for ratings and share prices. This means that there is a case for diminishing returns between forecast growth and share price performance.

Taking the analysis as a whole, the sector grouping with the most Hidden Gems is the UK house builders.

While this may appear counter intuitive, as share prices in this area have collapsed ahead of an expected housing slowdown, it is generally accepted that these companies tend to generate more cash into a downturn, as land is sold and costs reduced, than through more buoyant periods when house builders are typically highly acquisitive.

According to commentators, there is unlikely to be a better test of this theory than the expected market in 2008.

Smaller end of the market capitalisation scale 

Back in 2006, our HGI identified a range of companies with two common themes; smaller companies who could not raise profile and companies whose share price had yet to catch-up with reality.

In effect the latter theme could be split into two further areas; those companies whose forecast growth was yet to be recognised by share prices and those companies whose weaker prospects had been reflected in share prices but not in forecasts.

The 2007 analysis reveals a continuation of these themes. In the absence of companies such as Reckitt Benckiser (22nd in 2006), British Land (31st) and Imperial Tobacco (40th), however, the average market capitalisation of the Top 50 in 2007/2008 is markedly lower than 2006.

Thus, this year's HGI analysis has once again shown the cash generative qualities of Britain's SMEs; highlighting that the equity market continues to underestimate the extent of cash flow generation at the smaller end of the market capitalisation scale.

Maxwell added that it looks like many cash-productive businesses on the stock market could command a higher share price than they do, but they are constrained by their size or sector. 

He says that often the only time they can get recognition is when they are bid for.

Continued buoyancy 

In previous years many companies highlighted on this index were later subject to acquisition or bid speculation. For example, BPB, McCarthy & Stone, Pilkington, O2  and, most recently Northgate Information Systems, have all appeared in the HGI Top 50.

Maxwell explains that companies in this situation in the past faced a risk of takeover, potentially by overseas predators looking for a relatively inexpensive foothold in the UK or Europe or latterly private equity groups.

“Long-term, the sale of cash generative assets, which form the backbone of the UK economy could put UK jobs in jeopardy or make them at least more volatile," he adds.

The first half of 2007 was characterised by continued buoyancy in share prices and speculation over further corporate activity.

As the analysis highlighted at the time, on-going values were principally determined in reference to earnings and assets while bids were often based on cash flow modelling over the medium term.

This mismatch led to a two tier market whereby companies deemed too small, illiquid or simply unfashionable to be bid for languished on earnings-derived ratings while the more obvious bid candidates traded at substantial premiums.

Even more bearish conditions 

With market conditions changing for the worse, cash flow strength is likely to be far more central to investor considerations, Maxwell says that market signs are clearly pointing at more even more bearish conditions with a focus on the prospect of broken debt covenants for the first time in at least five years.

He believes that cash flow, represented by consistent cash generation, low gearing or both, is likely to be more important as a determinant of equity value than for some time.

"Whereas the last two indices have highlighted companies whose growth – with cash flow as a proxy – had either gone unrewarded or was overstated by analysts, the 2007/08 analysis potentially highlights the defensive nature of cash, making companies enjoying good cash flow far more appealing,” he adds.

The last six HGI studies have highlighted a critical factor in the relationship between the corporate sector and the equity market.

Companies are not simply valued on their fundamentals. Instead, issues such as the relative size of the company, the liquidity of its shares and the sector classification will all have an impact on its value.

The markets rollercoaster ride over the past few days is an example.

Stock market takes time to reward growth

Maxwell says that the research looks at stock market rating versus growth expectations.  With the potential for an economic slowdown, he believes that communicating strong cash flow both historically and in prospect is no bad thing.  

“It’s quite clear in today’s environment that the stock market takes time to reward growth but is quick to react on the merest hint of bad news. Well-run companies with clear strategy and strong operational cash flow deserve recognition even if not in the FTSE,” he adds.

Maxwell advises companies to review their approach to investors and:

1. Monitor the analysts’ forecasts for the company and seek to understand the method by which the shares are valued.
2. Communicate the key strengths addressing the issues including cash performance drivers.
3. Think through a defence document which addresses the key fundamentals of the business.

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Related links

• Grant Thornton