How to find high-quality AIM shares

A small-caps boom points to a strong shift to higher-quality stocks. Stockopedia’s Ben Hobson tells us how to track them down.

Despite the late summer sell-off in equities, the Alternative Investment Market is up by 7% so far this year. After a storming run since the post-pandemic lows of early 2020, that still means AIM is trading in sight of highs not seen since pre-2008.

For investors - especially stock-picking individual investors - AIM has proved to be a lucrative hunting ground over the past 20 months. But it hasn’t always been like this.

As the London Stock Exchange’s “growth market”, there have been some standout successes over the years, but also quite a few failures.

Since 2007, the overall number of securities on the market has fallen from nearly 1,700 to 835 today. But in that time, the value of AIM has soared by 52% to £148.8 billion. That points to a strong shift to higher quality, with many weaker stocks falling by the wayside.

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And while small-caps make up the vast bulk of companies on the market, a handful of successful large-caps have chosen to stick around. Today, the biggest company by market-cap is Hutchmed (LSE:HCM), a pharma investment company worth just over £4 billion.

Some of the others include the online fashion retailers ASOS (LSE:ASC) and Boohoo (LSE:BOO). Both stocks have valuations of around £2.5 billion, and between them they’ve been soaking up some of the biggest casualties in high street fashion retail over the past two years. Both have also been long-term favourites among investors.

Apart from being a natural source of small-cap growth plays, a crucial part of AIM’s appeal is its tax status.

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For a start, AIM trades are exempt from stamp duty. And investments in the majority of AIM companies are also effectively immune from inheritance tax if they’ve been held for more than two years. Being able to pass those shares along without triggering inheritance tax (IHT) at death is very appealing for many - although it does depend on individual circumstances.

Hunting for quality across a large plain

Despite the fall in the number of companies trading on AIM in recent years, there are still many, many stocks for investors to get to grips with. Faced with this challenge, one of the most useful strategy checklists to deploy is one that focuses on quality.

Quality manifests itself in different ways across different stocks, but applying a handful of important checks on long-term profitability can be a useful place to start. The “moat” checklist aims to detect signs of a robust competitive advantage, which is a hallmark of high-quality firms. While companies can achieve a competitive edge in all sorts of ways, the clues can almost always be found in the financials.

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Here’s how to think about that (and the metrics to look for):

• Lots of cash - look for companies in the top 20% of the market based on their percentage of free cash flow to sales.
• Efficient and profitable - a minimum average 10% Return on Capital Employed (ROCE) and Return on Equity (ROE) over five years.
• Pricing power - companies producing above average Operating Margins in their respective sectors over five years.
  Balance sheet health - companies that score a 7 or more on the 9-point Piotroski F-Score of improving balance sheet strength.

Using these rules, here are some of the highest-quality companies on AIM at the moment:

It’s important to stress that this quality checklist 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.

The strong momentum in the AIM market over the past 20 months reflects bullish sentiment among investors but also a marked improvement in the quality of its companies.

But by its nature, the growth stocks that trade on the market won’t always deliver blistering returns like this. So, a focus on finding the best-quality shares could be a sensible approach.

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