2 small-cap stocks you may wish to ignore

These two smaller companies could be worth avoiding if volatility and high valuations prove to be turn-offs that dent their share prices.

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With share prices generally making gains in recent months, it is unsurprising that some stocks now appear overvalued. While this may not necessarily mean share price falls in the short run, stocks which have bloated valuations could deliver underperformance over the medium term. Here are two companies which seem to fall into that category. As such, investors may wish to avoid them for the time being.

Mixed outlook

While integrated media company Tarsus (LSE: TRS) is forecast to record a rise in its bottom line of 78% in the current financial year, its performance in 2018 is set to be relatively disappointing. The company’s earnings are due to fall by 31% next year, which mirrors the performance of the business over the previous five years. In that time, its bottom line has flipped between double-digit earnings growth and double-digit declines in its bottom line.

Given the volatile nature of the company’s financial performance, its share price may come under pressure over the medium term. The outlook for the global economy is relatively uncertain and this could prompt investors to adopt an increasingly risk-off attitude towards the types of stocks they hold. As such, demand for Tarsus’s shares could fall and this could cause a decline in its share price.

Taking into account the company’s forecasts for the next two years, it trades on a forward price-to-earnings (P/E) ratio of 15.1. This suggests that it lacks a sufficient margin of safety to merit investment at the present time. Certainly, from an income perspective it may continue to have some appeal. Its dividend yield of 3.4% is covered 2.9 times by profit. However, in terms of capital gain potential, there seem to be better opportunities available elsewhere.

Stable performance

While Tarsus has recorded volatile earnings growth in recent years, filtration and environmental technology company Porvair (LSE: PRV) has been a consistent performer. It has delivered a rise in earnings in each of the last five years, with its bottom line rising at an annualised rate of 18.5% during the period. This robust performance could become more appealing to investors at a time when potential risks such as Brexit and Trump’s presidency are coming to the fore.

Looking ahead, Porvair is forecast to record a rise in its bottom line of 5% in the current year and 4% next year. While positive, they are behind the growth rates over the last five years. This could cause a problem for Porvair’s share price in future, since the company continues to trade on a relatively high P/E ratio. For example, its rating is currently 28.5, which indicates a much higher earnings growth rate may be required in order to justify its present share price.

Certainly, as a business Porvair seems to be performing well. Its acquisition of JG Finneran could prove to be a sound move, as the two businesses should be a good fit. However, in the near term its share price performance may disappoint due to what appears to be a failure by the market to successfully adapt its valuation to what may be a lower-growth period for the business.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

Peter Stephens has no position in any shares mentioned. The Motley Fool UK owns shares of Porvair. The Motley Fool UK has recommended Tarsus Group. 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.

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