Like Warren Buffett, Stockopedia's Ben Hobson has identified quality small-caps at marked down prices.
After a solid three-year run, the Alternative Investment Market (AIM) fell by 22% in the final three months of last year (see chart below).
It was the kind of pull-back in prices that leaves investors rattled - especially those of us holding the volatile, small-cap shares that you find on AIM.
Source: Stockopedia Past performance is not a guide to future performance
Yet last year's correction wasn't just confined to the UK's junior growth market. Last October saw America's Dow Jones Industrial Average suffer the biggest one-day points drop in its history (only for it to bounce back days later).
So, this was a correction that took hold across markets on both sides of the Atlantic, and across Europe as well. But in the aftermath, the consensus view was that there were no obvious reasons why equity prices had slumped at all.
This episode is a reminder of why day-to-day, week-to-week and even month-to-month movements in the stock market really shouldn’t matter to long-term investors. Periodic price swings are to be expected, but they can shake unwary investors out of the market. On this, it's worth considering the words of Warren Buffett, who said:
"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it."
Like Buffett, one way of preparing for inevitable periods of volatility is to use a strategy that offers greater confidence over the longer-term. One way of doing that is to focus on the market's higher quality companies. These are the stocks capable of generating higher rates of return and are less susceptible to whatever the market is doing. But when markets do fall back, it can be possible to buy these kinds of stocks at marked down prices.
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 percentage 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 percentage 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.
We sorted the list 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).
|Name||Mkt Cap £m||ROCE % 5y Avg||Operating Margin % 5y Avg||Return on Equity % 5y Avg||FCF/Sales %||Quality Rank|
The companies here all have impressive quality indicators in their numbers - but it's important to note that it's not always a failsafe approach. One company here - the concrete levelling specialist Somero (LSE:SOM) - recently issued a profit warning which may or may not be a momentary setback. But, in general, this strategy picks up some of the more solid, profitable and dependable stocks around. Many have held up in the conditions, while others like EMIS (LSE:EMIS) and Judges Scientific (LSE:JDG) have soared this year.
While smaller companies don't have the financial strength and maturity of large-caps, they can still carve out very profitable niches. This list of stocks includes AIM shares that are well known for their hugely profitable competitive power.
Last year's market pull-back was a reminder that equity prices are volatile and can come under pressure. 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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