If you’ve spent much time knocking around Aim, you’ll have an idea of what I mean when I say junk stocks.
My informal definition: a junk stock is a crappy company with a smart-looking website.
It’ll have a great story to tell about its product pipeline, its new contracts (not yet signed), and its big investment programme.
It’ll suck in investors, promising big gains. To keep the con going for a while longer it’ll issue more shares, and sells them to a new round of investors.
There are always more investors, right!
Aim is rife with them. And if you’re unlucky enough to own a few of them, they can totally wreck your investments.
They’re desperately frustrating because Aim is full of great little companies with big ideas and a big future. But they can be hard to find with so much junk floating about. Avoiding investing in junk is about the most important things you can do as an Aim investor, frankly.
That’s easier said than done though. Junk stocks can be hard to spot.
They usually have all the trappings of a great business. They tend to spend a lot of money on PR and on fancy websites. And their executives are total charmers.
But I’m here to tell you there’s another way! You can evade the chancers and blackguards. Read on for the details.
How to cut the junk
This time last year I was catching up on some new research into the financial markets. The research was carried out by heavyweight economists at the AQR hedge fund and the University of Chicago.
Anyway the research was describing, in very dry academic terms, exactly what I’ve written above. I realised as I was reading it that they were basically talking about Aim.
Here was their conclusion: if you cut out junk stocks, you can make way more money when you invest in penny shares.
And. More importantly. There’s a way to test for junk stocks in advance. In other words, you can tell which companies are most likely to make it when it’s time to actually buy the stocks.
They boiled it down to four characteristics: junk stocks don’t have them, real deal stocks do.
Briefly, here they are:
– They’re profitable. Four key measures of profitability: margins, gross profits over assets, free cash flow, return on equity.
– They’re growing. The “delta” of the previous numbers for profitability – basically how much those numbers have grown over the previous five years.
– They’re safer. This is shown by the stock’s volatility, and the amount of debt it has.
– They’re run for the shareholders. How much profit goes to shareholders, and whether the company dilutes existing shareholders by issuing more shares.
The new research is very clear: stick to companies with those four characteristics, and cut out the junk. Do that and you’ll have a massive leg up on the competition.
I’ve joined up with Standard and Poors, a financial software business, to put the idea into action. We’ve built a model which runs 17 different tests for junk across every small company in the market – exactly like in the research.
People need to hear about this! So I’ve written a report about my software package, and what it can do for ordinary investors.
I’m going to send you the report tomorrow at midday. So keep an eye out for it.