How to hunt down the best Aim stocks
There are three key factors to look for if you want to find the most promising stocks on the UK’s junior market, says Michael Taylor of Shifting Shares.
Aim (sometimes called the Alternative Investment Market) is London’s less-stringently regulated junior market. It’s designed to help young, small companies with potential for rapid growth (and unfortunately that’s often all it is: potential) to raise capital from interested investors. And there are certainly tempting-looking opportunities. Aim has produced a handful of extraordinary winners, such as Domino’s Pizza and online retailer ASOS, which have paid out spectacular returns to investors who got in early. However, it’s very much a stock-picker’s market – this is not a market for passive investing or index trackers.
Last week, in the first part of this article, we looked at three of the biggest mistakes that investors make when they first start out investing on Aim. To summarise, the three main mistakes new investors make are: failing to read the annual report thoroughly, and to work out how well management’s interests are aligned with those of shareholders; failing to pay attention to cash flow (which dictates whether a business lives or dies); and investing in firms whose business simply cannot grow beyond a certain point. In short, you cannot skimp on research and you need to be able to find your way around a set of accounts.
However, with that in mind, the good news is that if we know what to avoid, we can then focus and drill down for companies that exhibit the characteristics common to previous market winners. Here are three key features to look out for.
1. Return on capital employed (ROCE)
ROCE is a metric that measures the return a company gets on the capital that it spends on itself. Think of ROCE as the company’s own interest rate. For example, if a company invests £1,000 in its own operations and returns £200 in that investment, we would say the company has a ROCE margin of 20%.
Everyone knows the power of compounding (making interest on interest), and in this instance it works in much the same way. A company that can generate attractive returns on its investment in itself can then use those returns to reinvest in the business, leading to a virtuous cycle. This is especially profitable if the company itself is capital light (eg, it doesn’t have a lot of machinery or offices to maintain) and thus does not require significant amounts of maintenance capex. By increasing the amount it spends on growth, a company with a high ROCE can generate significant returns for its investors.
Fevertree, the upmarket mixer-drinks group, is a good example of this. Rather than produce the product itself, it outsources it – it’s a brand marketing company rather than a producer of mixers. Placing itself in the premium sector has given it high profit margins which can then be reinvested in the business.
2. Entrepreneurial management
One key common denominator of stockmarket winners has typically been a shrewd management team. Often these companies will still be run by their founders and their families, or by their descendants, which means that they are highly incentivised – often as much by a desire to uphold the family name as by a desire to protect and grow their wealth – to build the business up.
Management teams that view themselves as owners of the business tend to be well aligned with shareholders, which means that they will also likely act with the benefit of shareholders foremost in mind. Companies such as testing systems group AB Dynamics, and again Fevertree, have delivered outstanding returns for shareholders because the management teams involved were focused on increasing their wealth for the long term, rather than using the company as a temporary vehicle to finance a lavish lifestyle.
However, there can be such a thing as too much alignment with shareholders – be wary when there is a significant power imbalance, as it effectively means that small shareholders have very little ability to hold managements to account. For example, managements of companies with single large shareholders have been known to take their businesses private and keep them for themselves, rather than continuing to pay expensive listing fees. This is particularly tempting if they feel that the stockmarket is persistently undervaluing their company, or if they are fed up of dealing with the demands of the City. This is what happened with financial services company London Capital Group a few years ago. Management decided to delist and the share price promptly halved, as few people want to own illiquid shares in an unlisted business. Directors who also own a large enough stake in the business can act in the full knowledge that minority shareholders are unable to stop them. A recent example from a company which shall remain nameless is the director who decided he would pay himself an exorbitant sum from the company in order to use his home as an office.
3. Operational gearing
Companies that benefit from operational gearing – or scale – are companies that have large fixed cost bases, rather than costs per unit or service. This means that when business is good, profits rise sharply. Take the restaurant and bar business. Each individual premise commands a fixed price per month – rent, staffing costs etc – but once those costs are met, all of the additional revenues trickle down to the bottom line.
However, you do have to be aware that this type of operational leverage is a double-edged sword. It’s great when times are good, but if the punters are no longer delivering the footfall or spend, those fixed costs still need to be paid. Often, leases on premises run for fixed terms and have penalty clauses for early cancellation, which makes it very expensive or impossible for a struggling business to get out of them without bankrupting itself.
A better example would be online property portal Rightmove. The business has a fixed-cost platform and is hugely scalable (the cost base essentially stays the same, even as more and more agents pay to use it). As a result, Rightmove is highly profitable, and has delivered stunning returns for its shareholders.
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• You can download Michael’s free book on the UK stockmarket at shiftingshares.com