10 high-quality AIM shares for growth company investors

Stockpedia's Ben Hobson uses this quality checklist to find profitable and dependable small-cap stocks.

UK equity markets fell sharply last autumn and, while the main indices have clawed their way back, the Alternative Investment Market (AIM) has noticeably struggled to recover. After more than a year, the growth-focused smaller-cap index is still down around 20% on where it was before the slump.

You could argue that a loss of enthusiasm for smaller, more speculative stocks is no surprise in the current climate. Periods of economic unease - currently not helped by Brexit uncertainty - tend to spook growth company investors. So, AIM often feels it first when sentiment starts to cool.

Another clue to this protracted slump is that the AIM 100 index of the largest companies on the market has also failed to recover since the pullback last year. As it turns out, some of AIM's biggest names have come under serious pressure for various reasons over the past 18 months. 

Among them has been Burford Capital (LSE:BUR), the litigation funding specialist and one of AIM's largest stocks. It saw its valuation sliced from £3.5 billion to £1.5 billion in just a few weeks at the end of the summer after a shorting attack. Fevertree Drinks (LSE:FEVR), the upmarket seller of tonics and other mixers, has also lost some of its fizz. Its valuation has halved to £2 billion over the past year, although it remains one of AIM's biggest success stories of recent years. Even ASOS (LSE:ASC), the online fashion retailer and a long-term AIM favourite, has been out of favour. Its market cap has slid from £4.8 billion to £2.6 billion over the past 12 months.

What's interesting about stocks like Fevertree and ASOS is that their valuations remain relatively high despite their price falls. Both have been very popular shares in recent years and their valuations arguably carried a lot of expectation. When the market senses trouble (whether it's to do with the stock or the general outlook), these previously high-momentum shares can sell off sharply. But that doesn't necessarily that they become bargains. 

To get to the bottom of this, it can be worth calling on a quality checklist to assess the strengths and any weaknesses in a share. Unsurprisingly, some of the highest quality companies on AIM have track records of delivering solid, long-term price gains - so focusing on quality can pay.

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 % age 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 % age 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.

The list is sorted 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 ValueRank shows the value of each share - from zero (expensive) to 100 (cheap). In this case, most of these stocks are relatively expensive.

These companies all have impressive quality indicators in their numbers, with track records of strong profitability driven by high returns on capital and high margins. In general, this quality checklist picks up some of the more solid, profitable and dependable stocks around. Names like D4t4 Solutions (LSE:D4T4), James Halstead (LSE:JHD), Bioventix (LSE:BVXP) and Tracsis (LSE:TRCS) are all generally well-respected. Notably, Fevertree has some strong quality characteristics and ranks as the most expensive share here despite the recent fall in its share price.

Searching for quality

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

The slump on AIM over the past year is a reminder of how sensitive this growth-oriented market can be in times of uncertainty. Some of its biggest names have been buffeted, but many other high-quality stocks have held up well.

For longer-term investors, these phases are expected but nonetheless challenging. For that reason, it could be worth considering how a focus on higher quality shares could help you sleep sounder at night.

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