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4 Signs That Say This Small Stock Is a Possible Bargain

At its current share price of S$0.80, Micro-Mechanics (Holdings) Ltd (SGX: 5DD) is a tiny company in Singapore’s stock market given its market capitalisation of S$109 million.

But while it may be a small stock, Micro-Mechanics’ returns over the past 12 months have been anything but small. You see, the company’s shares have gained some 29% in price alone in that timeframe – it’s also pretty remarkable, in my opinion, when we compare Micro-Mechanics’ returns to the 25% decline that Singapore’s market barometer, the Straits Times Index (SGX: ^STI), has suffered over the same period.

After having had a great year, can Micro-Mechanics still be a long-term bargain for investors? It’s a tough question to answer, but there are four signs that suggest the company may still be worth at least a deeper look by investors.

An investing legend

Those signs come from the legendary investor, John Neff. Neff ran the U.S.-based Windsor Fund from 1964 to 1995 and generated a compound annual return of 13.7% in those 31 years, soundly beating the market’s comparable gain of 10.6%.

For some perspective, a $1,000 investment compounding at 13.7% per year for 31 years will become more than $53,000. Meanwhile, the same initial investment that’s growing at 10.6% annually over the same timeframe will be worth slightly less than $23,000.

Given his accomplishments, there’s plenty that investors can learn from Neff. In his book John Neff on Investing, he had shared the defining elements of how he had invested with the Windsor Fund.

Hallmarks of stock market winners

Within those elements that Neff wrote about are four that I think investors here in Singapore can use to help them efficiently narrow the universe of stocks into a more manageable number for further research. They are:

1. A low price-to-earnings ratio

Neff’s a bargain hunter at heart and he liked his stocks to be cheaper than the market. In Singapore’s context, we can use the SPDR STI ETF (SGX: ES3) as a proxy for the market since the exchange-traded fund (ETF) closely mimics the fundamentals of the Straits Times Index.

At the moment, the SPDR STI ETF has a price-to-earnings (PE) ratio of 10.6 – that could be the basis of comparison.

2. Strong fundamental business growth in excess of 7%

Neff also liked growing businesses. That makes sense, since a business that can’t grow would find it very hard to build value for its shareholders.

3. Having yield protection

A high dividend yield is an attractive proposition for Neff as that means that he can be paid while waiting for the market to recognise the value of a stock. Again, we can take our cues here from the SPDR STI ETF, which has a yield of 3.7%.

That shall be the yield-hurdle which stocks must clear.

4. A business with strong fundamental support

A strong business is an important thing for Neff. In his view, the return on equity can be an effective yardstick for measuring the strength of a business.

While Neff did not specify what is a healthy number to see for the return on equity, a general rule of thumb is that a figure of 12% (on a strong balance sheet that has minimal debt) is reasonable.

Keeping the four signs in mind, here’s how Micro-Mechanics’ business looks like according to data from S&P Capital IQ:

  • At its current price of S$0.80, the company has a PE ratio of 8.6 and a dividend yield of 6.25% thanks to its annual dividend of S$0.05 per share in FY2015 (fiscal year ended 30 June 2015)
  • Its earnings per share has grown at a compound annual rate of 14.6% over the past five years
  • It has a return on equity of 28% over the last 12 months with a balance sheet that currently has zero debt

As you can tell, Micro-Mechanics has cleared all the four hurdles with its low valuation, high yield, strong earnings growth, and high return on equity (while having a pristine balance sheet).

A Fool’s take

What I’ve shared about Micro-Mechanics may be useful, but like I mentioned earlier, Neff’s checklist is meant to help with just narrowing the field. A deeper look into other aspects of Micro-Mechanics’ business (such as its market opportunity and competitive advantages) is needed before any investing decision can be reached.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.