Top 10 quality AIM shares for 2016

In the 20 years since it launched, the Alternative Investment Market (AIM) has received mixed reviews for its ability to generate dependable investment returns. As the London Stock Exchange's market for smaller, growth companies, there have been some big winners, but some big losers, too. Last year the index of just over 1,000 companies saw a 5.2% gain, and an overall 14.4% rise from its largest 100 shares. This shows that exciting opportunities do exist for brave AIM investors, but finding good quality growth stocks needs some effort.

Why AIM shares are appealing

For individuals, part of AIM's appeal lies in its tax benefits. In 2013, the government lifted a restriction on holding AIM shares in tax-efficient Individual Savings Accounts (ISAs). It means that capital gains and dividends are now protected to an extent. Purchases of AIM shares are also free of the 0.5% stamp duty you pay for Main Market stocks. In addition, the majority of AIM shares, under certain conditions, are likely to qualify for inheritance tax relief. That means that they can be bequeathed without troubling the tax man.

These tax reliefs exist to encourage investment in smaller, riskier companies. But from a market-wide perspective, those risks can be scary. Research by London Business School last year showed that during the past 20 years, investors would have lost money in 72% of the companies that had ever listed on AIM.

But while these statistics are daunting, academic evidence in favour of buying smaller stocks is positive. For the past 35 years some of the most influential voices in finance have claimed that small stocks outperform large ones over time. They point to the "size effect" as one of the main drivers of long-term stock market performance.

In fact, "size" forms one of three main factors in an influential model of what drives returns, published by academics Eugene Fama and Ken French back in the early 1990s. And it's still applied by some of the most popular fund managers today.

Hunting for better quality AIM shares

To start sifting through the ranks of smaller stocks on AIM, it's worth introducing a few more factors to increase the probability of success. All too often investors agonise over the likely prospects of cash-burning oil explorers, mining companies and biotech stocks. Yet it's statistically, and historically, a better bet to focus on baskets of shares with higher levels of business and financial quality and positive price and earnings momentum.

In practice, that means assessing companies for their profitability, efficiency and balance sheet strength. And it means looking for those that have strength in their prices and are expected by analysts to stay on a growth trajectory.

At Stockopedia, we take some of the most useful measures of this type of quality and momentum and rank every company in the market based on how they score. In this screen for Interactive Investor, we've also included the dividend yield for each company and the level of dividend cover (anything more than 1.0 tells you that the dividend payment is covered by the company's annual earnings).

Searching for high levels of quality and momentum gives us a list of shares with wide-ranging market caps. The largest company here is James Halstead, which makes flooring for both the commercial and consumer markets. Among the others are Emis, which develops software systems used in the healthcare industry, and RWS, which is a support services group specialising in intellectual property and translation services. Like all the shares here, their ranking statistics put them in the top 10% of the market for the strength of both their quality and momentum.

Among the smaller companies is Character, the toymaker behind children's brands like Peppa Pig and Fireman Sam. At 3.8%, the highest yield on offer is also from one of the smaller companies: high street pawnbroking group H&T.

Yields of more than 3.0% are also attached to stocks like Zytronic, a digital displays business, Somero, a concrete levelling specialist, and NWF, an agricultural food, feed and fuels distributor.

Aiming for a successful result

Despite the tax benefits, AIM is an inherently risky market for investors. Smaller companies are naturally susceptible to unpredictable disaster, so careful analysis and adequate diversification are essential.

Few of the names on this list attract the high levels of internet bulletin board chatter that you see with many of AIM's more exotic "story stocks". In a market where the statistical likelihood of disappointment is so high, focusing on financially strong, dividend-paying businesses that are improving is perhaps a better place to start looking.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stock market investing website. You canclick here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

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It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Investment Strategies Editor at Stockopedia.com. His background is in business analysis and journalism. Ben researches and writes regularly on investment strategy performance and screening ideas for Stockopedia.com. He is the author of several ebooks including "How to Make Money in Value Stocks" and “The Smart Money Playbook”

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.