Five small-cap stocks worth a flutter

Britain's economy may be recovering somewhat, but it's still up to its eyeballs in debt. That's one reason why investors are constantly under threat from new and rumoured tax hikes.

Cuts in the pensions lifetime allowance, a potential lifetime limit on your individual savings allowance (Isa) pot perhaps even a ceiling on the amount you can take as a cash-free lump sum from a pension.

So, when the government actually offers a new tax-break for investors, it's hard not to sit up and take notice. Last summer, that's what gave the Alternative Investment Market (Aim) a big boost, as a previous restriction on putting Aim shares in your Isa was lifted.

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As a result, you can now invest in Aim shares via an Isa, and not pay any capital gains tax on your profits. Higher-rate taxpayers also save some income tax. And from28 April you'll no longer have to pay stamp duty (currently 0.5%) when you buy an Aim share. This all comes on top of the favourable inheritance tax treatment Aim stocks already attract.

Of course, you shouldn't buy any investment for the tax break alone. There's a reason governments have been wary of allowing Aim stocks to be held in Isas they are seen as a lot more risky than the average share. Aim is the junior market of the London Stock Exchange, with almost 1,100 companies listed.

It's more lightly regulated than the main market, and is supposed to be for smaller, often young, companies. The idea is that many Aim stocks will progress to the main market once they've matured.

On the one hand this is great it gives small companies an alternative way to raise money. On the other, it does mean you have to be careful.

However, there have been some incredible success stories. Internet retailer Asos now has a market value of £5bn. In August 2003 you could have bought the shares for as little as 3.73p. They now trade at £62.20. To put that another way, if you had invested £1,000 in August 2003, your investment would now be worth over £1.6m. As well as Asos, there are six other companies worth over £1bn on Aim.

But to me, the happiest hunting ground is in companies with market caps between £25m and £100m. They're small enough that they won't get much coverage in the City, which makes it easier to spot bargains, but they're not so small that they probably shouldn't be listed at all.

Going smaller also gives you an advantage over City professionals. Say you're a fund manager with £1bn under management. One day, you spot a really attractive Aim stock with a market cap of £20m. Even if you manage to buy 10% of this company without pushing up the share price, you'll only have invested £2m.

If the company's share price then doubles, you'll only have a £2m profit, which makes very little difference to the performance of your £1bn fund. Clearly, this isn't a worry for most private investors.

So what should you buy? Aim is renowned for being home to many resource stocks, often explorers that haven't yet discovered any commodity in commercial qualities. Obviously, these are high risk. I prefer small stocks that are already making a profit although I sometimes get lured by technology stocks that aren't making money just yet.

Below I've highlighted five Aim stocks that look attractive. My starting point is to look for companies with significant growth potential, then to look at the valuation. These aren't low risk by any means, and they may not turn into the next Asos but nor are they lottery ticket' stocks.

Four of my picks are profitable, while I reckon that the only loss-making share, Monitise, has the potential to be a FTSE 100 stock in a few years' time.

A punt on mobile money

My first pick is Monetise (Aim: MONI).The first thing I'll say about it is that it looks expensive. But don't let that put you off it still has the potential to go much higher. It's also much bigger than your average Aim stock, so while it's currently loss-making, it's no flash-in-the-pan punt on the success or failure of a single product.

Monitise provides infrastructure to support mobile banking and commerce fashionably known as mobile money'. That includes managing your bank account as well as buying goods and services with your phone.

More than 350 banks are Monitise customers worldwide, and it also has partnerships with Visa, Telefonica and IBM. By last September, Monitise had 24 million end users' people like you and me buying goods online and was processing transactions worth $50bn a year.

Revenue doubled lastyear to £70m afterseveral years of rapid growth. Some of that rise was due to acquisitions, but organic growth was impressive at 50%. The company is winning new contracts all the time and may go into profit next year.

Monitise splits its revenues into two categories: development and integration fees', and user-generated revenues'. The latter is the most exciting category these are the recurring revenues obtained each time an end-user carries out a transaction.

So, it's very encouraging to see that these revenues jumped by 247% to £43m last year. The more mundane development fees rose 25% to £29m.

So this is a very exciting company in a hot area of technology. The only trouble is that as I mentioned earlier its valuation is already rich. At 68p, the company is valued at £1.11bn, putting it on a very high price/sales ratio of 16.

If the next set of results (due 19 February) disappoints, the share price may drop. However, as far as I can see, no other company in the mobile money sector has such a wide range of products, customers and partners.

The sector will continue to boom, and Monitise is well placed to benefit. Combine that with the rapid growth rate, and I think the shares can sustain their rich valuation, and are still worth buying.

Potential in touchscreens

I love looking for areas with lots of growth potential, and touchscreens fit the bill nicely. They're everywhere Coca-Cola is installing touchscreen vending machines and I've seen big gaming touchscreens in a couple of hotels, including the one next door to the MoneyWeek office.

Zytronic (Aim: ZYT) is at the forefront of this market its customers include Coke and BHP Billliton. The company's latest development is curved touchscreens, which could be particularly appealing for casino customers, where novelty is highly prized in gaming machines as a way to attract new punters.

If you just looked at Zytronic's price/earnings ratio (p/e), you might think the company was a little dear, on a p/e of 16. However, what the p/e doesn't tell you is that Zytronic has a net cash pile worth £5.5m not bad for a company with a market value of just £33m.

If you instead look at Zytronic's enterprise value (EV) to earnings before interest, tax, depreciation and amortisation ratio (Ebitda), which takes the firm's cash situation into account, you get a much more attractive figure of 6.9. And the cash pile should give Zytronic the confidence to pay a 9.5p dividend this year, even though the payout probably won't be well covered by earnings.

Zytronic did issue a profit warning last May due to delays on some projects. But these delays haven't been fatal and we saw a partial recovery in sales and profits in the second half of the year. Without the profit warning, the share price would be much higher than its current level.

That looks like a buying opportunity Zytronic offers a combination of a decent yield, strong balance sheet, and exposure to a technology growth market. Just the sort of share that Aim was invented for.

A play on Japan

If, like me, you're bullish about Japan, Polar Capital Holdings (Aim: POLR) is a nice way to get some exposure through Aim. That's because Polar Capital is a fund-management company with an extremely popular Japanese fund.

Assets under management in the Polar Capital Japan UCITs fund have soared from $1.4bn (£850m) to $4.9bn in just a year, taking the firm's total to $11.4bn, from $5.3bn. Granted, we're in a bull market (or had been, until the last month at least), but that's still a very impressive jump in assets.

Polar Capital also pays a decent dividend and I like the fact that directors, staff and founders own 32% of the company. That level of skin in the game' should encourage management to focus on running the business for long-term success, rather than going for short-term gains.

Analysts believe that Polar Capital has the infrastructure to support further growth, so that should lead to increased cash flow in future. I'm also pleased to see that two of my favourite fund managers have stakes in Polar Capital Peter Webb, manager of Elite Webb Capital Smaller Companies Income and Growth Fund (see below, and Mark Slater, manager of MFM Slater Recovery Fund.

An endorsement from rival fund managers is especially valuable here this is their line of business, so they should have no trouble understanding it.

Sceptics could point to a p/e ratio of nearly 18, but I suspect Polar Capital can keep growing its assets and its earnings. Regardless of any short-term wobbles, the long-term outlook for Japan is good, which means the long-term prospects for Polar Capital are just as good.

Buy them while they're hot

Finsbury Food Group (Aim: FIF) isn't a high-tech growth stock, or a financial company it makes cakes and speciality bread for supermarkets. Why buy it? Simply because its shares are too cheap. Until 2012, investors worried that Finsbury's debt levels were too high.

But debt is no longer an issue, thanks to a share placing (where more shares are sold to investors), and the sale of one part of the business. Indeed, net debt is now just 12%, which is nice and low. This much-improved balance sheet has enabled Finsbury to invest in its manufacturing plant for cakes, which should cut costs and boost profit margins. One analyst thinks the investment could boost earnings by 20% in 2015.

This is good news, but there's no sign of a dramatic jump in cake sales. You have to look to the Nicholas & Harris speciality bread business for fast growth sales rose by 17% last year and now account for 27% of the group's total sales. As with most food businesses, margins are low at Finsbury, and as its main customers are the big supermarkets, that's not going to change. Indeed, margins may slip a little this year as Finsbury warned in January that it's been hit by rising prices for butter, cocoa and other ingredients.

However, I think these issues are fully reflected in the share price. Finsbury's EV/Ebitda ratio is too low at four, and I wouldn't be at all surprised if a bidder emerged perhaps from private equity.

One fund manager told me a private-equity buyer might be willing to pay as much as seven times Ebitda. Even if there's no bid, I'm not concerned.

The current management team is capable and should be able to grow the business, regardless of future pressure on costs.

Invest in esotericism

Pure Wafer (Aim: PUR) is a pretty esoteric business. It recycles test wafers' used in the production process for semiconductors. By reclaiming old wafers, Pure Wafer can save money for chip manufacturers most of the big chip firms are customers.

I was prompted to look at the firm when I noticed that top small-cap fund manager Giles Hargreave (see below) had a decent stake. What really stands out here is the valuation.

This company is trading on eight times last year's earnings, yet it's got decent growth prospects. As more and more products become connected to the internet, chip production should rise, and demand for Pure Wafer's recycling services should remain healthy.

Back in 2012 the share price was inthe doldrums due to concerns about excessive debt. But a share placing cleaned up the balance sheet and saw the share price more than double in 2013. Increased investment also enabled the firm to boost production and reduce costs.

The share price has fallen thisyear after the company said its Japanese rivals had been able to cut prices, thanks to the falling yen. That will probably reduce revenue this year by around 5%, but the company is confident there will be no hit to profits due to cost-cutting. I suspect that the impact of the falling yen is now very much in the price. In fact, markets are worrying too much about this issue. On a p/e of eight, Pure Wafer is too cheap.

The four bestAim funds

If you'd rather not invest in individual Aim stocks, you could diversify your exposure through a fund. Other than venture capital trusts (VCTs), there's only one fund that focuses explicitly on Aim the Cavendish Aim fund (tel: 020-8810 8041), and even this fund can invest in stocks on the main market if it wishes.

The fund hasn't performed that well when compared to many small-cap funds with a wider remit, but the manager, Paul Mumford, has a good reputation and his non-Aim funds have done well.

What's more, the Cavendish Aim fund only has £30m under management. That means it can still be flexible and take advantage if Mumford sees an undervalued stock with a low market cap.

The obvious alternatives are small-cap funds that have a high weighting to Aim. Unfortunately, some of the best have been soft-closed' to new investors in other words, either the initial fee is very high or the minimum investment is in the region of £100,000.

One of the best open' funds is the Marlborough UK Micro Cap (0120-439 8676). Over five years, it's delivered a 290% return and it's the fourth top-performing small-cap fund over that period. Over 80% of the fund is invested in Aim and manager Giles Hargreave has an excellent reputation.

The SF Webb Capital Smaller Companies Growth Fund (0800-800 008) is also worth a look. It's run by Peter Webb, who was a successful manager in the 1990s and early 2000s. His record isn't perfect and he stepped back from the City in the late 2000s for a few years, but early signs suggest he could deliver a strong performance over the next few years.

A full 81% of his fund is invested in Aim, and the big draw is that the fund only has £4.7m under management, which means that successful tiddlers can make a dramatic difference to its performance. That's more of a challenge for the popular Marlborough Micro Cap fund, which has £260m under management.

Another option is to invest via some specialist venture capital trusts that focus on Aim. The Unicorn Aim VCT (LSE: UAV) has a good track record and is the largest such fund.