The central principle of the junior Alternative Investment Market (Aim) is to provide small growth companies with the capital they need to realise their potential. So it seems fitting that an Aim screen should focus on hunting down high-growth stocks. Another key characteristic of the Aim market is that it is off the radar of many large institutional investors and, as such, is a place where private investors can find overlooked, under-researched and undervalued situations. So it also only seems right that our Aim screen should also try to find undervalued shares. With this in mind, I've attempted to concoct a screen that brings together both factors to unearth cheap, high-growth stocks.
The screen draws on the method of famous US fund manager Peter Lynch by using EPS growth rates as the primary screening criteria. When looking for high-growth shares, Mr Lynch was interested in earnings growth rates of over 20 per cent, but was cautious about anything over 50 per cent as this is probably too high to be sustainable for long. But Mr Lynch concentrated his search for stocks on larger companies. Given that the focus of my Aim screen is on early-stage growth, I've differed from his methodology and set the limit on growth at between 20 per cent and 100 per cent as I don't want to exclude companies in a really explosive stage of their development. To test the veracity of EPS growth, I've demanded that historic revenue growth is equivalent to at least half historic EPS growth. The logic behind this test, which draws an approach advocated by another famous American fund manager, John Neff, is that sustainable EPS growth must ultimately be supported by sales growth.
As a valuation yardstick, I am using the 'genuine-value' ratio I devised earlier this year. The ratio has much in common with many well-known investors' preferred valuation metrics, including the 'dividend-adjusted' price-to-earnings-growth (PEG) ratio used by Mr Lynch. The main difference with the genuine value ratio is that it tries to take account of the debt and cash on a company's balance sheet by employing the enterprise-value-to-operating-profit ratio (EV/Ebit) in place of the ubiquitous PE ratio. The formula is: