10 high-quality shares on the AIM market

The AIM market has been well positioned to benefit from Covid-19 uncertainty. Here are ten profitable, competitive stocks.

It has been a rocky ride for investors in UK shares this year. After the dramatic pull-back in March, and until only recently, the FTSE All Share has been drifting. But it has been a much more upbeat story on the growth-oriented Alternative Investment Market (AIM). A surging run has seen AIM more than recover its lost ground, which is intriguing for a market that has historically been seen as a riskier place to invest.

At least part of the reason for the difference is that a relatively small number of the very largest companies on AIM have done well this year. It makes a big impact on what is a predominantly small-cap index when multi-billion pound market-cap stocks like ASOS (LSE:ASC), Hutchison China (LSE:HCM), Boohoo (LSE:BOO), Abcam (LSE:ABC)and Fevertree (LSE:FEVR) do well. 

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Another feature of the AIM market in 2020 is that it has been well positioned to benefit from stocks and sectors that have managed to thrive in the Covid-19 uncertainty. In particular, areas like online retail, biotech, technology, renewables and even some areas of the mining sector have performed admirably.

Of course, predicting these trends and areas of outperformance at the start of the year would have been close to impossible. But that’s not to say that there aren’t promising stocks to be found on AIM. On this, it’s worth considering the words of legendary investor Warren Buffett, who said:

“Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it.”

Like Buffett, one way of preparing for periods of volatility is to use a strategy that offers greater confidence over the longer-term. One way of doing that is to focus on the market’s higher quality companies. These are the stocks that are capable of generating higher rates of return and are less susceptible to whatever the market is doing. But when markets do fall back, it can be possible to buy these kinds of stocks at marked down prices.

Higher-quality firms can often be found from tell-tale clues in their financial statements. For a start, the most profitable and durable companies tend to have high levels of free cash flow as a percentage of their sales. You also often see high operating margins and an ability to produce strong, stable returns from invested capital, which can be seen in measures like return on capital employed (ROCE) and return on equity.

With this in mind, we took these ideas and screened AIM to see which companies passed the tests.

The rules we used included:

• Companies in the top 20% of the market based on their percentage of free cash flow to sales.
• A minimum average 10% return on capital employed and return on equity over five years.
• Companies producing above-average operating margins in their respective sectors over five years

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We sorted the list based on Stockopedia’s QualityRank, which takes into account long-term quality factors, balance sheet strength and any potential accounting or insolvency risk red flags - from zero (poor) to 100 (excellent).

The companies here all have impressive quality indicators in their numbers. And while it’s not always a failsafe approach, this strategy picks up some of the more solid, profitable and dependable stocks on AIM. Many have held up in the conditions, while others like Bioventix (LSE:BVXP), Sylvania Platinum (LSE:SLP), Cerillion (LSE:CER) and Team17 (LSE:TM17) have performed very well in 2020. 

While smaller companies don’t have the financial strength and maturity of large caps, they can still carve out very profitable niches. This list of stocks includes AIM shares that are well known for their profitable competitive power. 

This year’s market pull-back was a reminder that equity prices are volatile and can very quickly be at the mercy of events. For longer-term investors these phases are always a possibility, but are nonetheless challenging. For that reason it could be worth considering how a focus on higher-quality shares could help you sleep sounder at night.