Buying unloved penny stocks can be very rewarding. Small-cap shares are often lightly traded and slower to react to good news than larger stocks. When they do recover, they can move fast.
Of course, this strategy isn’t without risk. Sometimes a small, cheap company is like that for a good reason. Things can always get worse, too.
For this reason, I focus even more than usual on financial health and profitability when I’m buying shares in small companies. If the fundamentals are strong and the shares look cheap, I hope I’ll have some protection against big losses.
A bargain in plain sight?
The company I’m going to look at today is specialist brickmaker Michelmersh Brick Holdings (LSE: MBH).
Shares in this business have fallen by 35% over the last two years as the market has priced in a housing downturn. However, Michelmersh’s trading has remained strong and the group’s financial position looks very healthy to me.
2 hidden attractions
I think this business has two attractions that might not be obvious at first glance.
One is that this the firm operates at the premium end of the market. Michelmersh’s brick brands include Charnwood, Blockleys, and Carlton. According to the company, it currently “owns most of the UK’s premium manufacturing brick brands”.
The attraction of premium branding is that builders buying these bricks don’t just want the cheapest product possible. They want the specific quality and appearance of Michelmersh products, and they’re willing to pay for it.
More generally, UK brick manufacturers have been unable to satisfy demand during the housing boom of recent years. Imports have made up the shortfall. But importing bricks is expensive, as they’re heavy and bulky.
If housebuilders cut back on new builds and brick demand slows, then I’d expect UK bricks to be chosen ahead of imports. That could help to protect UK brickmakers from falling demand.
Strong trading + cash pile
Michelmersh’s latest trading update seems to support this view. In November, the company said that 2022 results should be ahead of expectations. The order book for 2023 was said to be “strong and well-balanced”.
This business also has plenty of cash, thanks to double-digit profit margins and careful management. At the end of November, net cash was around £8.5m. That’s roughly equivalent to one year’s profits, providing a useful safety net.
The obvious concern is that as construction activity slows down, Michelmersh will see demand for its products fall. I can’t be sure that this won’t happen, but as I’ve mentioned above, I think the company’s distinctive brands and financial strength should provide a margin of safety.
Too cheap to ignore?
Michelmersh shares currently trade on a 2023 forecast price-to-earnings ratio of nine, with a 4% dividend yield. Broker forecasts suggest the firm’s earnings will be flat in 2023, before returning to growth in 2024.
I believe the shares look cheap at this level. In my view, this is one of the most attractive penny stocks on the UK market today.
