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Time to get greedy with these battered small-cap stocks?

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While the FTSE 100 index continues to flirt with new highs, the past few weeks haven’t been quite so kind to some small-cap investors. That further underlines the importance of evaluating your attitude to risk before hunting for promising companies lower down the market spectrum.

But should recent falls in international toy distributor Character (LSE: CCT) and marketing group System 1 (LSE: SYS1) be regarded as a warning to stay away, or an opportunity to get involved? Here’s my take.

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Devoid of character?

Having traded as high as 540p at the start of September, shares in Malden-based Character have since lost 30% of their value, driven partly the bankruptcy of Toys R Us in the US and Canada, but also by the company’s international customers becoming increasingly careful with their cash.

Last week’s trading update seems to have stabilised things for the time being. The company reiterated that is had witnessed a “solid finish” to the 2017 financial year with underlying pre-tax profit expected to meet market estimates. Moreover, sales in the UK remain comparable with those of last year and similar to trends witnessed in the toy industry in general.  

So long as investors are able to look beyond the short term, the outlook doesn’t look too bad either. While Character’s management already believes that the company will perform “significantly below” previous market estimates over the next year, a return to growth on the back of new product launches is expected in H2 2018, even if the full effect of this reversal won’t be seen in the numbers until the 2018/19 financial year.

Right now, you can pick up shares in the £82m cap on a bargain-basement valuation of just eight times predicted earnings. That looks a seriously good deal for a business boasting consistently high returns on capital, no debt, and a chunky, fully-covered 4.6% yield.

Big faller

Character’s investors will no doubt sympathise with the owners of  System 1, formerly known as Brainjuicer. Following a number of concerning updates, the latter’s shares have now halved in value since momentarily breaching the £10 mark in May. 

Perhaps unsurprisingly, last Monday’s six-month trading statement appears to have done little to attract investors back to the stock. Confirmation was given that H1 trading had been “slower than expected” after a significant reduction in spending by some of its clients. Indeed, pre-tax profit from the first half is now expected to be around £800,000 – over 70% less than that achieved over the same period in 2016. Factor in reports that the company’s market has become increasingly more competitive and it’s not surprising that System 1’s management remains “cautious” on the outlook for the rest of the financial year, citing a “usual lack of revenue visibility“.

With so much uncertainty around and the stock still trading at 17 times forecast earnings, it would appear many market participants are waiting for signs of improvement before making a move. Next week’s interim results will certainly make for interesting reading.

In the meantime, it’s worth remembering just how well System 1 has performed over the years. Like Character, it’s consistently generated high returns on the money it invests and boasts a net cash position. Free cashflow is excellent. And while its growth status means that System 1 offers little attraction to income hunters, its nine-year dividend growth streak isn’t to be sniffed at.

The company remains on my watchlist.

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Paul Summers has no position in any of the shares mentioned. 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.

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