It feels like it’s been a while since my last outright purchase. And there is good reason for this. It is becoming extremely difficult to find value within the big blue chip companies I like to invest in. On the FTSE 350 index, there are not many shares I am willing to buy at current levels as I believe many of them are overpriced. The three companies I believe that are offering decent value at present are GSK, Imperial Brands and Shire but with all my recent monthly purchases, these three stocks are fast becoming full positions – they already account for 17% of my portfolio. (For full disclosure, I bought more of these stocks in my December monthly stock purchase programme but I always tend to write about these at the end of the month).
With investible ideas hard to come by, I have had to expand my investment universe and start looking in to smaller companies and the Alternative Investment Market (AIM) they are listed on. Many investors call the AIM the graveyard for investors as they have lost money investing in companies listed on this market over the years. But then again you get the success stories such as ASOS, BOHOO, CVS and Fevertree. With the AIM, I believe ones due diligence and investable standards should be higher as it is easy to invest in a lemon. So far, my AIM investing history has been mixed having invested in only two stocks on this smaller London market so far. My Zambeef shares bought in 2015 has more than doubled but my Accrol Holdings position is currently experiencing a loss as written about a few weeks ago.
One such company listed on the AIM offering great potential is Solid State (LON:SOLI). The company specialises in so-called ruggedized electronics – ruggedized essentially means that the products are designed for use in a harsh environment. Typical industries are transport companies. They also work with military and construction firms who have specific requirements for products, such as toughened touchscreens.
Ruggedized electronics, being a very niche market, is one of the aspects that drew me towards solid state. Players in niche markets usually tend to be very profitable. Looking at the finances of Solid State, this seems to be the case. One of my favourite metrics to look at, Return on Capital paints a bright picture with the average figure over the last 10 years being 17%. Even during the lows of the financial crises, the figure remained in double digits at 13%! This shows that the company is using its money really well to generate returns and this will be for the benefit of the shareholders. Furthermore, the company has strong operating margins, healthy cash flow generation and a balance sheet with net cash on it.
Another aspect that has drawn me to the company is that family members and management have a significant ownership stake in the business. Together these two parties control over 25% of the business which shows that any decision they make will be for the befit of the company and be value accretive to shareholders. This may seem like an obvious point but Ive seen too many stories play out where management in smaller companies make decision that benefit them as opposed to the shareholders/owners. This agency problem is a big factor when investing in smaller companies and that it why you need to ensure management have a vested interest in tech company in the form of significant ownership. Just to go off on a bit of tangent whilst we are on this topic, this rule should be applied when investing in mutual funds as well. When making a decision as to which fund to invest in, make sure the investment manager has his own money tied up in the fund. Terry Smith of Fundsmith sets a great example regarding this and that is why his is one of the only funds I invest in.
The valuation of the company also looked compelling when I bough my shares. At my purchase price of 3.98, the P/E ratio was just over 13. This is compelling value for a company with very attractive characteristics. The dividends yield of 3% is also compelling considering the company has ample room to grow it in the coming years. For my 176 shares, I am expected to receive just over £21 in annual dividend income which I expect to grow in the coming years.
Pitfalls To Avoid In Small Stocks
As mentioned above, your due diligence should be extra thorough when investing in smaller companies. I have looked through the accounts of many small cap AIM listed companies and it occurred to me that many junk companies share common attributes with each other. Whilst the below list is not exhaustive, it is a good starting point in finding companies to avoid:
- Constant Dilution of Equity
Equity capital is the most valuable capital a company can have. Besides the low hurdle rates many companies place on vested options for management, I’ve seen many companies pay for services in stock. If management has determined that they’re willing to hand out shares to newsletters, ad agencies and websites for the equivalent of a Google Ad mention it gives investors good idea of how valuable management believes their shares are. If management treats their equity like toilet paper then the equity is probably as valuable as toilet paper.
- A tax heaven incorporation
Setting up a company in a region classified as tax Heavens is notoriously easy. A few forms and a check and you’re on your way. These regions are also notorious for having the fewest protections for shareholders. There are legitimate companies with tax heaven charters, but they are few and far between. If you find a company suddenly went dark with your investment you won’t have the right to look at the books unless you own a significant and potentially controlling interest in the company. This isn’t true for most other regions where a single share grants you legal rights.
- Too many adjustments in the accounts
When a business produces final reports that have too many ‘one-off’ adjustments, it is best to run for the hills. This may be the time to start looking for forensic accounting firms so that the financial reports can be thoroughly checked. A quick check on the previous years financial statements will show that these “one-off” adjustments existed then and no doubt many of these will exist in the future.
- Annual reports that appear to be copy and pasted from Excel
Maybe this is a minor nitpick, but it’s a pet peeve of mine. There are companies that either take screen shots, and yes they’re sometimes blurry, of their financials and paste them into the annual report. Or outright copy and paste them, with cell borders and all into the annual report. It strikes me as lazy. That the CFO couldn’t spend an additional two minutes removing the cell borders, or cleaning up the sheet.