10 best small-cap momentum plays around

2017 has been a terrific year for UK quoted smaller companies. So far, the Alternative Investment Market has notched up a near-20% gain, while the FTSE SmallCap is up by 8.5%. But with more than a thousand stocks across these indices, investors have to navigate their way past a host of risky, low probability stocks as they hunt for high performance.

One of the consequences of the fast flow of funds into smaller shares over the past 18 months is that a number of them now look expensive. Against popular valuation measures it's easy to argue that some of these stocks look pricey - and some look very stretched indeed.

But for some investors, 'expensive' isn't necessarily a bad thing. It can be a pointer to firms that fully deserve a premium rating, and may well have a lot further to go. These are the market's high flyers.

The hallmarks of a high flyer

High flyers have a very distinctive profile. They tend to be very good quality, in terms of both their franchise and financial strength. Plus, they tend to have strong momentum both in the price of their shares, but also in their track records of earnings growth. The catch is that the market finds these features desirable, so these kinds of stocks rarely look cheap. And that can put many investors off them.

If you applied this combination of high quality and momentum at any price to large companies right now, you'd be looking at stocks ranging from SSP and Renishaw to Diageo, Just Eat, and ASOS. These companies have robust financial strength and solid performance histories, but their price charts giveaway just how much the market values these characteristics. The momentum in these shares can be breathtaking.

Digging into the detail

There are some basic places to look when it comes to pinning down the traits of high quality, strong momentum shares. Good quality companies are highly profitable with strong industry-leading margins. They are stable, growing and often have accelerating sales and earnings. They also have strong and improving financial histories and no signs of accountancy or bankruptcy risk.

In turn, strong momentum will show up in stocks trading at, or above, their 52-week highest prices and are performing strongly against the rest of the market. They'll often be beating broker estimates and seeing estimate upgrades and recommendation changes.

At Stockopedia we simplify all this by scoring and ranking every company in the market with a Quality Rank and a Momentum Rank - taking the above measures into account. To be a true High Flyer, these stocks would also have to rank fairly low against our third ranking factor, the Value Rank.

Applied to fast-paced smaller company indices like AIM and the FTSE SmallCap, these are the sorts of companies we're seeing at the moment.

The Value Ranks of these stocks are relatively low, bearing in mind the ranking ranges from zero (very expensive) to 100 (very cheap). But the combined quality and momentum scores are impressive.

Leading the top five is the marketing software business dotDigital, which is followed by a very diverse group of companies ranging from the wine retailer Majestic Wine, engineering group Avon Rubber, photonics specialist Gooch & Housego and investment manager, Polar Capital.

One of the arguments in favour of looking for high flyers among small companies is that the large companies of tomorrow are most likely to be found in this territory. So, knowing what to look for, and catching these companies early, can give investors a big advantage.

But it's also true that small companies can fail more easily than larger firms, so it's important to be careful. Likewise, quality can deteriorate in some businesses, and strong momentum can collapse if the story changes. But paying a higher price for better quality shares on the move is a proven strategy of playing two very powerful drivers of returns in the stock market. High flyers won't fly high forever, but they can deliver stunning returns over long periods.

About Stockopedia

Interactive Investor's Stock Screening series is written by Ben Hobson ofStockopedia.com, the rules-based stockmarket 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.

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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.