This year, I am going to focus all of my attention on AIM (Alternative Investment Market) listed stocks. The AIM market was launched in 1995 in the UK and allows smaller companies raise money from investors without the regulatory burden and cost associated with listing on the main market.
Since inception, the performance of the AIM market has been very poor. From 1998 up to the end of April 2019, investors buying a basket of all AIM stocks as tracked by the FTSE AIM All Share Index have gained a paltry 7% while UK RPI inflation has increased by 74%. Investors would have slept better and made more money by simply leaving their money in the bank instead of investing in an index tracking AIM listed companies.
While most investors will look at this chart and recoil away from AIM listed companies, this is exactly the type of chart I like to see. Why? Because whenever investors have an automatic negative opinion of a stock simply because of where it is listed, it creates opportunities.
Also, Mifid II regulations will limit research from sell side analyst within banks and brokerage houses and will no longer be offered to asset managers for free. This research was previously bundled up for free with other services however, asset managers must now pay for such research separately. If asset managers choose to bring research in house, which some probably will do, this will reduce coverage of small and micro caps in the EU which could mean lower liquidity and more volatility. This will make some of the smaller overlooked stocks on the AIM even more overlooked which is great news for a stockpicker.
In mid-April when I started looking more closely at the AIM market, it had 922 listed stocks. I went through all of them, alphabetically, and applied two filters. First a negative filter to remove companies I would not consider spending more time researching. This is important when going through a large list of stocks and allows you to focus your attention on a smaller pool of less speculative companies. I filtered out companies with poor economics, fads, possible frauds, speculative biotech and oil exploration companies.
How do I filter out fads? Common sense. Companies linked to anything that is in vogue at the moment and is highly speculative like crypto currencies, marijuana, graphene etc is automatically filtered out.
How do I filter out frauds? This is more difficult without digging into the financials and researching management. However, to save time, I simply exclude any company with significant exposure to countries with a low Corruption Perception Index (CPI) score.
Speculative biotech and pharmaceuticals are quite easy. In their business summaries, two verbs often crop up that are a very good sign of poor economics, whenever they mention the fact that they are “developing” or “commercialising” some new technology or drug, it is usually accompanied with a company that constantly issues new shares and doesn’t generate any operating cash flows. These companies can have large binary outcomes if the new technology or drug they are developing is a failure or success. However, I am not interested in large binary outcomes. The base rate for this type of companies succeeding is quite low and I don’t have the knowledge to make a good judgement about their odds of success. These are automatically excluded.
The same goes for oil exploration companies, they have large binary outcomes and the base rate of success is low.
After the negative filtering, 133 companies remained. The second part of the filtering process is applying a positive filter, inspired by the Piotroski F score but focusing on metrics that I consider more important. I also fix what is, in my opinion, a limitation of the F score in that some of its metrics focus only on 2-year results.
For positive filtering, I am looking for companies that are easy to understand, quality, have contracts (literal or metaphorical) and are cheap. If the stock meets my metric, it gets a +1, if it doesn’t it gets a 0 and if its too expensive it gets a -1. Lets go through this metrics one by one.
Easy to understand is the simplest metric – a company qualifies if I understand its business model on first reading. This doesn’t mean that complex companies are bad, they will however rank lower in my screen and be researched later on. I am looking for the one-foot hurdles that Buffett often talks about.
The next metric is quality. This is composed of three sub metrics:
- Normal ROE ≥ 10%
- Stable operating margins: Coefficient of variation of operating margins over a long term representative time must be ≤ 25%. Here I am looking for some measure of predictability
- Not excessively leveraged. Net debt/EBITDA ≤ 2
For each of these metrics, the stock either gets a +1 if it is met or a 0 if it isn’t.
The next metric I look for is a company with contracts. I wrote about this briefly here, here and here. Essentially I am looking for a company with literal or metaphorical contracts with its customers. A company needs to have some kind of contract with its customers before you can assume cash flows are sustainable. When initially analysing a company, it is difficult to tell if it has contracts. However, some signs that I look out for are: a company with a niche product and a long operating history, a key supplier to highly regulated industries like chemicals, defense, aerospace, nuclear, energy production, food industry etc. If it isn’t immediately obvious that the company has some kind of contract it gets a 0 on this point. This is updated if further research shows otherwise. I am once again looking for obvious one-foot hurdles and focusing on companies that have some sort of contract with their customers.
The final metric is price. How cheap is the stock? Here, each stock can get a -1 if it is too expensive, 0 if it is fairly priced and +1 if it is cheap. What do I mean by cheap and too expensive? EV/EBITDA < 10 is cheap. For a fast growing company, I can accept higher multiples however my absolute limit is EV/EBITDA = 20. EBITDA numbers are always normalised.
So, we have 6 metrics in total: easy to understand business, high normal ROE, stable margins, not excessively leveraged, contracts with its customers and cheap.
Each stock can score a maximum of 6 points and I prioritise any stock which has a score of 5 or higher for further research. The benefit of having a -1 point for stocks that are too expensive is that their maximum score is capped at 4 so no matter how quality a stock may be, it isn’t at the top of my research list until it gets cheaper.
After positive filtering, I was left with 41 stocks that are cheap and quality. I will be posting my writeups on some of these stocks here and elsewhere in the coming months.