The Alternative Investment Market (AIM) is the London Stock Exchange’s junior market for growth stocks. Its purpose is to offer a cheaper route to market for smaller companies that are looking for equity capital to grow.
As such, governance might not be as strict when compared to companies listed on the main market. This sometimes leads to a few questionable companies listing on AIM.
But not all AIM-listed stocks are the same. So, here’s my three-point checklist for finding quality shares on AIM, and one that I think will outperform for me from here.
Screening for high returns
The first thing I do is set up a screen to look for businesses that achieve consistently high return on capital employed (ROCE). This measures the profitability of a company relative to the capital it requires to generate those profits.
Capital here takes into account both equity and debt. So a company that can generate high profits with little equity and debt capital would achieve a high ROCE – a sign of a quality business. Because I want consistently high ROCE, I screen for a five-year average.
Instead of screening for companies that, say, achieve a five-year average ROCE of above 15%, I rank all stocks on AIM from best to worst instead. This is so I don’t miss a potentially good stock that just misses my threshold.
High margins
The next thing I look at is operating margin. Or how efficient the company is at generating profits on the revenue it generates. I consider anything above 15% as attractive for my portfolio.
This has left me with three stocks at the top of my ROCE stock rank.
Shareholder alignment
Finally, and maybe most importantly, I look to see if company management own the shares of the business themselves. If the executive team and board members own shares of the business, then their own interests are aligned with shareholders. This really helps with corporate governance too.
I particularly like to see the CEO and chairman of the board owning shares. Even better is if the CFO is buying the stock too, because this person should know the company financials better than anyone.
The result
Now that I’ve ranked by ROCE, checked operating margin, and ensured management own the shares themselves, I found an excellent stock for my portfolio: K3 Capital.
K3 Capital has a five-year average ROCE of 70.6%, an operating margin of 16%, and management owns lots of shares too. In fact, the CEO himself owns over 11% of the company, and the chairman owns 1%.
The firm provides business brokerage and corporate finance services. The share price is already up 32% this year as the company has taken advantage of the ongoing boom in M&A. However, if this boom cools then profits will suffer. But K3C is diversified across corporate restructuring and tax advice too. I consider the shares a buy for my portfolio.
Dan Appleby owns shares of K3 Capital. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.
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