How to track down the best quality high flying shares on AIM

The Alternative Investment Market has risen in value by around 40% since last June’s EU referendum. And while that performance is echoed right across the market, there’s evidence that AIM is starting to fight off some of the criticism often levelled against it. Specifically, there are signs of improving company quality, although it’s still the case that AIM is home to a lot of stocks worth avoiding.

Over the past 10 years, the number of companies quoted on AIM has fallen from 1,694 to around 967. Critics argue that’s a problem and that falling numbers highlight just how risky the market actually is. But it can also be argued that this decline has been a cleansing experience for AIM. It’s removed a lot of highly speculative, poor quality shares that shouldn’t have been there in the first place.

In terms of numbers, analysis of the coming and going of AIM stocks suggests that the decline might be slowing. Accountancy firm UHY Hacker Young says the number of companies leaving AIM dropped by 16% in the 12 months to the end of March, falling from 105  to 88. By contrast, the number of companies joining AIM rose by 5%, from 38 to 40. And funds raised in AIM IPOs rose from £753 million to over £919 million.

In terms of the market’s recent performance, the researchers at UHY credit positive trends in commodity prices and tech valuations for driving up the index valuation.

But there’s also evidence of more structural reasons for AIM’s positive trends. A recent survey of investors by the Quoted Companies Alliance - including the likes of Hargreave Hale, Downing and Schroders - found improving sentiment towards it. In particular, it found that fund managers see AIM as better now than it has ever been, with fewer failures and more quality.

However, it wasn’t all good news. Among the criticism, some managers claimed AIM’s performance had been “way below what a high risk market should be”, while one said that it was clogged by a large amount of “sediment” at the bottom of the market; micro caps that can’t get critical mass or the liquidity needed to attract investors. Others noted that a lot of AIM companies are dysfunctional and shouldn’t be listed and that the some AIM Nominated Advisers and Brokers are poor quality.

Ways to fish in the AIM pool

The idiosyncrasies of smaller-cap AIM stocks mean that detailed research is essential in every case. This is where the type of work done by Stockopedia’s Paul Scott and Graham Neary is so invaluable. But it’s possible to get started in this research by taking a more systematic top-down approach.

The list below begins to slice-and-dice AIM by selecting those stocks with the highest combined company quality and share price momentum - using the Quality-Momentum (QM) Rank. In terms of quality, the rank considers companies that are profitable with high industry leading margins, stable, growing and ideally accelerating sales and earnings. It also considers a strong and improving financial track record and no signs of accountancy or bankruptcy risk.

In terms of momentum, this shows up in stocks trading at, or above, their 52 week highest prices and performing strongly against the rest of the market. They’ll often be beating broker estimates and seeing estimate upgrades and recommendation changes.

Often these high flying shares can appear to be expensive, but the style rests on the power of a combination of quality and momentum. And it’s a style that can be found in some of the most successful stocks in the market.

The results of this style approach really show off the broad spectrum of stocks that you find on AIM. Topping the list is the micro-cap security and surveillance systems business, Petards. But it’s followed by one of the largest, best known and most remarkable success stories on the market last year, Fevertree Drinks. This approach also lands you squarely in the realms of some of the most exciting and closely followed shares in the market, namely the likes of Bioventix, Somero Enterprises and Amino Technologies.

From a psychological perspective, the problem with high flyers is that their strong momentum is often a deterrent to investors who feel that they’ve missed a big move. There can always be an argument that’s true. But the comparatively high quality of these firms can offer some comfort that they may have much further to go (although some may not). And with momentum, there is a constant risk that missed expectations can cause sharp pull-backs in price. So like High Flyers in any part of the market, they need to be watched closely.

It’s encouraging that there are signs that AIM is maturing and that quality on the market is improving. But the long tail of ‘sediment’ still poses a risk to the unwary. A focus on the market’s better quality High Flyers is perhaps the best placed to get started.

You can find the simple High Flying AIM stocks screen here.