Top 10 AIM growth stocks for a market breakout

Stalking the stock market for value shares is a tried and trusted approach for many investors. But not everyone wants to spend their days scratching around for opportunities among basket cases and 50/50 recovery plays.

Investors like William O'Neil, Philip Fisher, Jim Slater and Peter Lynch earned reputations as spirited adventurers on the hunt for tomorrow's explosive growth stocks. They did it by either disregarding valuation altogether or paying a little extra for shares with the promise of exciting growth. With the AIM All-Share breaking out in April, with a 5.4% rise, it’s worth assessing some growth stock strategy rules to see which small-caps could benefit most from improving sentiment.

Fast and persistent earnings growth

A company's historic profitability and the expectation that its earnings will keep growing is a crucial factor in any growth investing strategy. Back in the 1930s, the "father of growth investing", US asset manager T. Rowe Price, put earnings growth at the centre of his strategy. He looked for a long-term rising trend in earnings per share (EPS) and used forecasts to predict whether earnings would keep growing. US investor William O'Neil uses a similar approach in his trademarked CAN-SLIM strategy, which also looks for accelerating EPS and sales growth trends.

Growth at a reasonable price

Value hunters have a wide range of measures at hand when it comes to valuing shares. But growth investors tend to be more cautious about using ratios like price-to-earnings when analysing stocks. Philip Fisher, an investor famed for influencing the approach of Warren Buffett, aimed to buy stocks that offered growth at a reasonable price (otherwise known as GARP). He looked for a track record of consistent sales growth as one of his leading indicators. Unlike many value investors, Fisher was content to keep holding shares even when they became fully or over-valued in the market.

One of the best known measures of the relationship between value and growth is one made famous by investors like Peter Lynch and Jim Slater. Using the price-earnings growth factor, or PEG, they measured the trade-off between a stock’s price, its earnings and its expected growth rate. Both men worked out the PEG slightly differently but with the common aim of buying growth at an acceptable price. A PEG of less than 1 indicates that a company is growing EPS faster than its price-to-earnings ratio, and can be a pointer to cheap growth stocks.

Positive price trend

Peter Lynch is well known for his desire to find "tenbaggers" - stocks that can literally make him ten times his original investment. But to do that, those stocks need to be consistently breaking new price highs, which means that tracking relative strength against the market is vital for growth investors.

Slater uses positive price performance as a clue that investors are beginning to notice a company's potential. He looks for high relative strength in the previous one-month and 12-month periods compared with the market. A similar approach is used by O'Neil who uses relative strength to find the very best price performers in strong sectors.

Screening for growth

Using some of the main drivers behind successful growth investing strategies, Stockopedia screened the AIM All-Share for Interactive Investor. Common factors such as historic and forecast earnings and sales growth are combined in the GrowthRank, which ranks companies from zero (worst) to 100 (best). The results are restricted to stocks with a market capitalisation of at least £50 million.

Topping the list is veterinary services group CVS, which has grown considerably in recent years through acquisitions. Its price has nearly doubled over the past year to around 603p and it looks expensive on almost every measure. Yet, its sales and earnings growth have been impressive. CVS is followed by Telford Homes, a property developer in London, and Clinigen, which supplies pharmaceuticals and services and recently announced a £225 million acquisition of medical supplies business Idis.

Elsewhere on the list is Plus 500, an online trading platform, which saw revenues nearly double in 2014 to £229 million. Other consistent growers include Solid State, an electronics manufacturer, and Abcam, a medical research supplies business which has seen a resurgent share price in 2015, helped by improving earnings forecasts.

With the benefit of hindsight, this portfolio of stocks would have produced a pre-costs return of 49% over the past year.

Watch out for growth risks

Some of the world's best known investors have made a name for themselves by chasing growth stocks, but it’s worth remembering that excessive sales and earnings growth can be risky. Smaller cap companies can be susceptible to overextending themselves, manipulating earnings and competitive threats. And with high valuations, bad news or disappointments will be punished by the market. So hands-on research into balance sheet health is essential, and with the right research it may be possible to find market-beaters.

As Jim Slater explained: "With any system based on small to medium-sized growth stocks, you are seeking to identify a few super-growth shares and hold on to them through thick and thin. Selection is far more important than timing."

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click 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 Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"