The tax wrapper benefits of an ISA are always useful but never more so than when applied to fast growing small caps that offer the potential for massive capital appreciation and equally massive capital gains tax. But for investors looking to get the most out of the capital gains negating benefits of an ISA by owning AIM shares, there are three key factors that I always look for.
This is always an important factor in choosing an investment but is especially critical when it comes to investing on the AIM, where corporate governance standards are significantly more relaxed than on the main market and there are thousands of examples of management teams running roughshod over minority investors.
So what things should you look for to ensure an AIM-listed company is respecting corporate governance standards? The first step is the board of directors. The board should ideally be majority independent non-executive directors, who in a perfect world will be more likely to stand up to management if they propose something at odds with the interests of minority shareholders.
Another key standard is insider ownership. We all love a company where management has a hefty chunk of their wealth tied up in shares but the AIM is rife with firms where a single shareholder owns more than 50% of voting rights in the company. Just ask shareholders of Sports Direct for a real life example of why this can be terrible for minority investors.
This should be common sense but it’s amazing how many people get suckered in by the latest hot AIM share that promises life-changing opportunities are right around the corner for shareholders. We all know how rarely they wind up a fairy tale for these investors.
In the same vein as profitability, investors should also keep a close watch on a company’s cash flow statement. The more cynical among us will want to do this to look for fishy accounting practices that could indicate fraud.
The more trusting investor will still want to look for positive free cash flow as it indicates the company has a viable business model and is able to fund expansion through retained earnings. Relying on internal funding is important for investors because it lessens the chances of shareholder dilution through rights issues. This is a particularly common problem in the resources sector, where early shareholders can see their holdings winnowed down significantly over time if a company continues to tap shareholders to fund investment in mines, oil wells etc.
Again, a healthy balance sheet is something investors should look for in all potential investments but is particularly important when looking at small caps such as those on the AIM. Low levels of debt and healthy doses of cash point to a business that is in rude health and will be able to hopefully both continue expanding and return cash to shareholders.
While these tips won’t remove all the risk of investing on the AIM, looking for good corporate governance standards, solid profitability and a healthy balance sheet will certainly go a long way towards weeding out the riskiest investment opportunities. And for all its risk, the AIM can oftentimes be great places to find under-researched, under-valued small-caps with a bright future, the perfect complement for your ISA.
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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended Sports Direct International. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.