The Best of AIM, the Worst of AIM

The Alternative Investment Market (AIM) is seen by many as a hunting ground for stocks that can generate vast returns. These are the types of fast-growth small-caps that ex-Fidelity fund manager Peter Lynch once called 10-baggers. Over the past five years they’ve included the likes of Judges Scientific, Walker Greenbank and ASOS. But despite these successes, many AIM companies are hugely speculative, pre-earnings ‘story’ stocks. That means they often go on to disappoint their shareholders. Last weekend we helped The Telegraph track down some of the best and worst quality shares that AIM currently has to offer. This is what we found...

Many investors look in the wrong place

Changes to tax rules last year made it much more appealing for investors to trade AIM stocks. But while their allure might have grown, our research shows that many investors go about finding the best AIM shares in completely the wrong way. A general rule in the stock market is that good, cheap companies tend to outperform expensive, speculative companies. But if you look at this bubble chart - it shows that the most discussed AIM stocks on bulletin boards have a completely different profile to what works.  

Focus on Quality and Value

Good quality, attractively priced companies were precisely what hedge fund manager Joel Greenblatt set out to find when he devised his Magic Formula in ‘The Little Book that Beats the Market’. His system ranks companies using just two metrics - return on capital (good) and earnings yield (cheap) - to find those with the best combination of both.

Stockopedia’s StockRanks take these ideas even further by ranking shares not only for their quality and value but also their ‘momentum’. Many studies have shown that adding share momentum to a value investing approach has historically reduced risk and improved the consistency of returns.

The aim is to highlight good, cheap and improving stocks, while shunning speculative, expensive, deteriorating stocks. The results since we launched the rankings a year ago have been quite eye-catching - with the top 20% of stocks above a £20 million market cap returning 34% while the bottom 20% returning a negative 16%. Please do join our StockRanks webinar next Wednesday to learn more.

Finding the best of AIM

Using these quality and value principles, we put together a pair of stock screens to filter for the ‘Best of AIM’ and ‘Worst of AIM’ (subscribers can see the full results by clicking those links).

To make it on to the Best of AIM screen, companies need a minimum market cap of £100m. They also need consistent and high profitability - with a current and 5-year average return on capital of over 10%, operating margins in the top 50% of their sector and a Piotroski F-Score of over 6/9 (which illustrates strong and improving fundamental health). Few of the stocks on the list are clearly ‘cheap’ anymore because the market has been bidding them up. But many have P/E ratios that are falling below 20x next year due to expected profit growth. Most of them also have improving broker forecasts.

Among them is Sprue Aegis (LON:SPRP), the company that makes consumer safety products like fire alarms under brand names such as Fire Angel and First Alert. Supply deals with the likes of B&Q, Tesco and Boots contribute to a strong return on capital of 30.4%. According to our StockRank calculations, Sprue ranks in the top 2% of the whole market based on the most common signs of quality in a business.

Recruitment company Staffline (LON:STAF) has seen its price soar on improving economic conditions. Its current P/E of 31 falls to 16 next year and its return on capital of 16% is around double the average for the recruitment sector. Unsurprisingly, it ranks very highly when you score it against multiple measures of quality, value and momentum, with a StockRank of 94/100.

Profitable niches and a defensible edge

Heating and cooling equipment hire business Andrews Sykes (LON:ASY) boasts some eye-catching quality credentials and likes paying dividends too. Its high return on capital and operating margins suggest this is a business in a strong position to squeeze profits from its hire services. In terms of value, Stockopedia’s Value Rank merges six common valuation measures to get an overall ranking score. In this case, Andrew Sykes scores 78 out of 100, which puts it in the top 22% cheapest shares in the market. The expected dividend yield for next year is 4.4%.

Elsewhere, Advanced Medical Solutions (LON:AMS) operates in another profitable niche - developing woundcare dressings - essentially providing adhesives to ‘glue’ wounds rather than stitch them. The shares have risen strongly over the past year but unlike many healthcare companies on AIM, this one has the hallmarks of a strong balance sheet and achieves high margins from product sales.

Finally, earnings have been growing a double digit rates at Italian food chain Prezzo (LON:PRZ) in recent years. Restaurant groups that hit on a winning concept can often go on to produce exceptional shareholder returns. Just by opening new outlets they can ‘clone’ their operations. This is what happened at Frankie & Benny’s owner Restaurant (LON:RTN) and it could be happening at Prezzo too. A return on capital of 15.6% an overall StockRank of 84/100 point are positive signals.

Avoiding the worst of AIM

By contrast, the Worst of AIM screen simply looks for companies with very poor fundamental profiles. A return on capital of less than zero highlights those that are loss making and an F-Score of less than 5 means they have poor and deteriorating fundamental health. A further filter used here is the ‘M-Score’, which can flag up poor accounting quality.  Filtering further to look in the bottom 20% of the market according to the Stockopedia StockRank reveals the more expensive and weak of these speculative companies.

These include Nanoco (LON:NANO), which makes nanoparticle technologies that are used in lighting and solar. Nanoco has seen its net losses grow every year for the past five years as it invests in its futuristic tech. On conventional valuation metrics like price-to-book and price-to-sales, it looks very expensive even though its share price has fallen by 44% over the past 12 months. That negative price momentum suggests investors may be losing enthusiasm for it. There are very few signs of a strengthening balance sheet, with an F-Score of just 3/9 and a poor showing against the M-Score.

Heavy promotion to private investors led to a rapid rise in price at web commerce company Blur (LON:BLUR) in 2014. However, two profit warnings in quick succession sent the shares tumbling. For many months it has also been flagging highly for accounting risk based on the M-Score. The classic signs that can indicate aggressive accounting are very visible - growing receivables, low accruals and super-high sales growth. Overall it achieves a low StockRank of just 1/100. The company is now in discounted funding talks at barely 10% of its high price reached only four months ago.

Overstretched and deteriorating

Also flagging on this screen is defence and security business Westminster (LON:WSG). Its shares rose strongly last year but a sharp fall since April suggests the market is now uncertain. Westminster has lost money over the past three years. With a price-to-book value of 61x, it is one of the most expensive companies in the market on this basis. It also has a very poor showing against the Beneish M-Score of accounting risk. Given these factors, it’s unsurprising that Westminster scores just 3/100 for its combination of quality, value and momentum.

With a market cap of £170 million, Silence Therapeutics (LON:SLN) is among the largest of a number of predominantly loss-making drugs developers on AIM. But with no sales and wide losses, Silence’s quality characteristics are naturally negative and it achieves a low StockRank of 17/100.

Finally, shares in cloud-based IT and business communications business Outsourcery (LON:OUT) have fallen sharply in recent weeks. The company is endeavouring to sell cloud services to major organisations, but it’s an arduous process. Sales are growing but ongoing losses mean the it is flagging as an insolvency risk and also shows signs of accounting weaknesses. Overall it achieves a StockRank of just 1/100.

Tread carefully with AIM companies

With changes to tax rules making AIM stocks more appealing to private investors, it’s worth remembering that smaller companies need careful handling.  So many investors throw money at speculative or blue sky companies without an understanding that these areas of the market are low probability bets best left to venture capitalists. While our screening uncovered a number of potentially strong businesses that are able to profit from defensible niche positions their share prices are reflecting this strength.  

Of course as Warren Buffett once said: “it’s far better to buy a wonderful business at a fair price than a fair company at a wonderful price”. The challenge of deciding which are the wonderful businesses amongst those that indicate strength is what makes stock market investing so pleasurable to so many. DYOR and Safe Investing!