How to screen the market for high quality AIM shares

The Alternative Investment Market (AIM) is popular with investors looking for fast-growing companies that have the potential to deliver exceptional returns. But the challenge is that there are literally hundreds of stocks to choose from, many of which are very risky and highly speculative.

In this article we’re going to look at why AIM is so popular and how you can use the Stockopedia Screener to find the market’s highest quality shares.

AIM was launched in its present form in 1995. Unlike the Main Market, it has a light-touch regulatory regime that’s designed to be less of a burden on smaller, growth-oriented companies.

Some of these stocks go on to re-rate many times over, but many others are unproven, unprofitable and rely on appealing stories to attract investors. Ultimately, hype and expectation often gives way to disappointment and losses.

Indeed, despite the market being set up for young companies, many are too small, too unfamiliar or have too little liquidity to attract mainstream institutional funds. As a result, they don’t get much in the way of analyst coverage either.

But while this is undoubtedly a big risk with AIM, it also gives regular investors an advantage. For those prepared to do their homework, there can be an edge in getting to know these under-researched companies well.

Over time, the number of stocks quoted on AIM has grown a great deal, peaking at over 1,700 in 2007. But in the aftermath of the financial crisis there was a shift to quality. Weaker companies fell by the wayside and overall numbers fell below 1,000. As a result, the quality bar improved and funds flowed into the market, sending its value higher.

Today, AIM is home to a number of exciting businesses. A few have grown so large that they wouldn’t be out of place in the FTSE 100. But it’s still the vast array of smaller, innovative growth stocks that prove to be AIM’s real appeal.

Improving quality and major tax benefits

It isn’t just the large numbers of growth companies that makes AIM attractive. It also has some important tax benefits.

For a start, purchases of AIM shares are exempt from stamp duty taxes. This saves paying the 0.5% tax that’s triggered when buying shares worth more than £1,000 on the Main Market.

Meanwhile AIM enjoys all the same benefits as Main Market shares when it comes to Stocks & Shares ISAs. Depending on individual circumstances, these wrappers can be used to shield AIM investments from both capital gains and dividend taxes. That can do a lot to enhance compounding gains over time.

Finally, investments in the majority of AIM companies (but not all of them) are also immune from inheritance tax if they’ve been held for more than two years. This works because most AIM companies qualify for what’s called Business Property Relief. One of the advantages of this arrangement is that the shares are shielded from IHT, which is very appealing for many investors.

Hunting for quality across a large plain

While the number of companies trading on AIM has fallen in recent years, there are still a lot of stocks to get to grips with. Many are relatively young, unproven and often unprofitable. So a useful strategy checklist to deploy is one that focuses on finding high quality companies.

Quality can show up in all sorts of ways in different companies, but there are some universal tell-tale signs to look for. The best companies often have defensible competitive advantages in their markets. Having that generally leads to the kind of consistently high levels of profitability that are both a major advantage in business and a huge attraction for investors. To find evidence of a track record of solid profitability, company accounts hold the clues.

How to do this with the Stockopedia Screener

Here’s how to construct a Stockopedia Screen looking for high Quality AIM shares, together with some of the metrics you might choose to use:

• A business that generates lots of cash from sales

In the Screener, we start by selecting the AIM All Share Index as our focus, and include a minimum market capitalisation of £10 million in order to strip out the very smallest companies from the results.

The next step is to look for “cash cows” by using the Free Cash Flow to Sales ratio. With this ratio, anything over 5% can be a clue to a good quality company. But rather than absolute numbers, this step uses a “ranking rule” to filter the market for stocks in the top 20% based on the FCF/Sales ratio.

• A business with strong profit margins that may point to pricing power

Profit margin is a measure of a company’s income after all of its operating costs are deducted. The higher the margin, the better and likely more profitable the business will be. High margins can be a pointer to companies that have strong control over what they actually charge their customers.

Margins are best used to compare companies in similar industries because they often have similar cost structures. So with this rule, the screen looks for companies that rank above average in their own sector based on profit margins.

• A business that is good at generating a profit from its operations

When it comes to understanding a company’s profitability, there are a couple of important longer-term measures that can tell you a lot about how efficient it is.

One is Return on Capital Employed, which is a measure of how good the company is at generating income from the capital it re-invests in itself. A consistently high double digit ROCE can be a pointer to firms that are ruthless at generating profits. In this screen we’ve looked for a 10% minimum both over the past year and on average over five years.

Another is Return on Equity, which is a measure of how efficiently a company uses Shareholders’ Equity to generate profits. Again, a consistently high ROE over time points to a very efficient profit-making business. Again, we’ve looked for a 10% minimum both over the past year and on average over five years.

Results from these screening rules should offer ideas for further investigation. While there may be exceptions and other factors to consider, stocks passing these rules share some high quality financial measures that can be a strong pointer to some kind of profitable competitive advantage.

The full screen can be found here.

A checklist to find high quality shares

It’s important to note that, as with any quality checklist, this won’t always protect you from setbacks. Even high quality companies can see their share prices tumble when their results don’t meet expectations. But these rules are a solid starting point in finding competitive and very profitable businesses.

Importantly, the focus on looking at medium term averages with these quality measures means that you’re less likely to be tripped up by companies that are having one exceptional year, rather than being exceptionally good all the time.

Improving quality across the AIM market in recent years is very positive for investors, but there are still lots of risky and speculative, low quality stocks quoted. So a focus on finding the best quality shares is a sensible approach.