5 top tips to avoid losing your shirt on AIM stocks

The more than 900 companies on London's AIM market have the potential to deliver life-changing profits for investors. A prime example is Asos, now AIM's biggest company, which has turned £1,000 into £2.95m since floating in 2001.

However, despite some huge individual winners, the AIM index is no higher today than its launch value of 1,000 points in 1995. Hundreds of companies have come and gone over the years and the majority have been utter disasters for investors.

Here are my five top tips to avoid losing your shirt on AIM and increase your chances of finding one of the big long-term winners.

Tip #1 - Check directors' histories

As legendary investor Warren Buffett says, integrity is the single most important quality to look for in business managers. Without it, the other desirable qualities of intelligence and energy will kill you.

Seek out independent verification of the backgrounds and CVs of AIM directors. Stay away from directors with histories of serial business failure, or who've been investigated for or convicted of any financial wrongdoing, or whose CVs cross the boundary from embellishment into fabrication.

In addition to a general internet search, the Companies House website is a great resource.

Tip #2 - Learn about creative and fraudulent accounting

Investing time learning about company accounts should repay you in the long run. In particular, knowledge of accounting shenanigans can steer you away from potential disasters-in-waiting.

There are numerous ways companies can cook the books. An internet search for "aggressive accounting" will take you to sources for learning about the signs of potentially creative or fraudulent accounting. The more "red flags" a company's accounts contain, the higher the risk there's something seriously wrong. Erring on the side of caution is prudent.

Tip #3 - Accept nothing less than clear and honest communication

As shareholders, we are part-owners of any company we invest in. And we should expect to receive -- in addition to accurate accounts -- clear and honest communication from those we've tasked with managing our business (the directors).

Companies that tell outright lies, that lie by omission or otherwise mislead shareholders in annual reports and other regulatory statements, at AGMs or in informal press or online interviews should be given short shrift.

Tip #4 - If it looks too good to be true...

If a company is trading on a ridiculously cheap valuation, you should take it as a warning to steer well clear, rather than as an invitation to pile in.

In particular, I've never known anything other than a bad outcome for investors buying a company trading at a large discount to net cash (that's to say, when its market cap is a small fraction of the net cash on its balance sheet). The market is essentially signalling that it doesn't believe the cash is there and that the company is an outright fraud. If a valuation looks too good to be true, it probably is.

Tip #5 - Diversify

Even if you follow tips one through four, it's the nature of the small-cap universe that even good, well-managed businesses can encounter serious problems or even go under. As such, you can lose your shirt by going all-in on a single stock or a very small number. Diversifying your AIM portfolio across a range of companies will not only decrease the risk of you being wiped out, but also increase your chances of alighting on one of the market's life-changing winners.

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G A Chester has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.