Should I buy this AIM-listed growth stock for my portfolio? Here, I’m going to look at the investment case for K3 Capital shares today.

K3 Capital: a high-quality company

There’s a lot to like about K3 Capital from an investment perspective, to my mind.

For starters, the company has a strong long-term growth track record. Between FY2016 and FY2021, for example, revenue climbed from £8.55m to £47.2m. That represents annualised growth of more than 40%.

Looking ahead, City analysts expect the company’s top line to keep rising. For the year ended 31 May 2022, the consensus revenue forecast is £60.4m. For the following financial year, it’s £74.8m. This is encouraging. It’s worth noting that in a recent trading update, the group advised that recent trading had been “positive”, and that it was “very confident” in its outlook for the year (just passed).

Secondly, the company is very profitable (it has a 5-year average return on capital of 60%) and pays regular dividends. Last year, it paid out 9.1p per share to investors. At the current share price, that equates to a yield of around 3.4%, which is certainly attractive in today’s low-interest-rate environment. Analysts expect the payout to keep rising in the near term. Dividends are not guaranteed going forward though, and forecasts can change.

Finally, the valuation seems very reasonable. With the consensus earnings per share forecast for this financial year sitting at 21.9p, the forward-looking price-to-earnings (P/E) ratio is just 12.3. That seems low to me, given the growth the company is generating.

One big risk to consider

One concern I have, however, is the cyclicality of the business.

Given that K3 Capital specialises in UK SME (small and medium-sized enterprises) business sales and advisory services, its fortunes are linked to the health of the UK economy. If the economy was to experience a downturn, the company could be impacted quite badly.

We’ve seen this before with K3 Capital. For example, in FY2019, revenue declined 18% and earnings fell 34% due to challenges associated with Brexit. As a result, the share price tanked.

Given that many economists are predicting a recession in the UK in the near future due to the cost-of-living crisis, there’s certainly an element of uncertainty here. The high level of growth we’ve seen from K3 Capital in recent years could come to an abrupt end if economic conditions deteriorate.

K3C shares: my move now

Given this risk, I’m going to leave K3 Capital shares on my watchlist for now.

In the current environment, I think there are safer growth stocks I could buy today.

What does K3 capital do

The company provides advisory services to small and medium-sized enterprises under three heads. The first of these is mergers and acquisitions, which includes services like company sales and corporate finance services. The next is tax advisory, which includes all kinds of services related to taxation including tax credit claims and tax investigations-related works. And then there is its restructuring advisory, which provides insolvency and restructuring-related advice, analysis of business performance, and forensic accounting services. 

Growth across segments for the UK stock

In its recent trading update, K3 Capital said that all business divisions have performed well in the six months ending 30 November 2021. It now expects that revenue for this half-year to have almost doubled from the year before. An increase in profits is also expected. As per CEO John Rigby, the board “is confident in the prospects of the Group for the remainder of FY22 and beyond”. 

The company expects growth through both the organic route as well as through acquisitions. In fact, the past six months’ performance reflects two recent acquisitions that took place in July 2021. Clearly, the company is doing a whole lot right, considering that between 2018 and 2021, its revenues have increased by three times. 

Downside to the AIM stock

Its share price has also risen by a healthy 46% in the past year. However, not all is hunky-dory. Its over the years, its share price has fluctuated a fair bit. And its price-to-earnings (P/E) ratio is also pretty steep at 46 times. I guess this is partly because it has performed quite well recently. Still, considering the uncertain times we are living in, I do think that this is a very high for a relatively small firm. It has a market capitalisation of £275m, which is certainly not among the smallest, but it is a far cry from big FTSE 100 companies. And this industry segment could suffer if the recovery continues to be muted because of the Omicron variant. 

What I’d do now

Keeping this in mind, I will not buy the AIM stock right away. I will wait for the whole Covid-19 situation to play out over the next month or so. This will give me a better assessment of how things might look for it in 2022. If they do continue looking bright, I would very much like to invest £1,000 in the stock next year. If they falter, however, I will keep it on my investing watchlist, and buy the UK stock when the time looks right. In the meantime, I will focus on more predictable stocks. 

As such, governance might not be as strict when compared to companies listed on the main market. This sometimes leads to a few questionable companies listing on AIM.

But not all AIM-listed stocks are the same. So, here’s my three-point checklist for finding quality shares on AIM, and one that I think will outperform for me from here.

Screening for high returns

The first thing I do is set up a screen to look for businesses that achieve consistently high return on capital employed (ROCE). This measures the profitability of a company relative to the capital it requires to generate those profits.

Capital here takes into account both equity and debt. So a company that can generate high profits with little equity and debt capital would achieve a high ROCE – a sign of a quality business. Because I want consistently high ROCE, I screen for a five-year average.

Instead of screening for companies that, say, achieve a five-year average ROCE of above 15%, I rank all stocks on AIM from best to worst instead. This is so I don’t miss a potentially good stock that just misses my threshold.

High margins

The next thing I look at is operating margin. Or how efficient the company is at generating profits on the revenue it generates. I consider anything above 15% as attractive for my portfolio.

This has left me with three stocks at the top of my ROCE stock rank.

Shareholder alignment

Finally, and maybe most importantly, I look to see if company management own the shares of the business themselves. If the executive team and board members own shares of the business, then their own interests are aligned with shareholders. This really helps with corporate governance too.

I particularly like to see the CEO and chairman of the board owning shares. Even better is if the CFO is buying the stock too, because this person should know the company financials better than anyone.

The result

Now that I’ve ranked by ROCE, checked operating margin, and ensured management own the shares themselves, I found an excellent stock for my portfolio: K3 Capital.

K3 Capital has a five-year average ROCE of 70.6%, an operating margin of 16%, and management owns lots of shares too. In fact, the CEO himself owns over 11% of the company, and the chairman owns 1%.

The firm provides business brokerage and corporate finance services. The share price is already up 32% this year as the company has taken advantage of the ongoing boom in M&A. However, if this boom cools then profits will suffer. But K3C is diversified across corporate restructuring and tax advice too. I consider the shares a buy for my portfolio.

K3 earns its living advising Small and Medium-sized Enterprises (SMEs) on matters regarding Mergers & Acquisitions (M&As), tax and business recovery. And it aims to expand both organically and via “complementary” acquisitions.

The growth strategy is working

And the strategy is working. I’d describe today’s full-year results as barnstorming! In the 12 months to 31 May, the business delivered a revenue increase of 215% compared to the prior year. And adjusted earnings per share shot up by 50%.

The directors rewarded shareholders by pushing up the total dividend for the year by 22%. And City analysts predict a further dividend hike in the current trading year north of 30%. I think it’s fair to say they expect further growth in the business. And the directors are certainly making positive noises about the outlook.

But although I’m hoping for those analysts’ estimates of double-digit earnings advances ahead to materialise, I’m also keen to collect income from the dividends. The forward-looking yield for the current trading year to May 2022 is running near 3.5%. And I think it’s rare to find UK shares with robust underlying growth prospects and a decent dividend yield.

Looking ahead, chief executive John Rigby said the business is now “cyclically balanced”. And he thinks it’s capable of performing well “across the entire economic cycle.” However, I think predictable revenues and profits could be hard for the company to achieve.

There could be cyclical challenges ahead

When times become tough for many businesses, they often chop consultant and advisory services from their budgets to save money. And even if K3 manages to keep its own turnover and profits on an even keel through any future economic downturns, investor sentiment could take the share price lower. I don’t anticipate a smooth ride holding the stock, but I’m encouraged by the long-term growth trajectory of the business.

And there’s no denying how busy the company has been in pursuit of growth. During the period, K3 raised just over £30m to feed its acquisition strategy. It signed off on five acquisitions, launched two new service lines and established one new joint venture.

Then in July, after the end of the period, the company raised a further gross £10m. And it announced an intent to acquire Knight Corporate Finance and Knight R&D to extend the M&A and Tax offerings of the overall business.

The forward-looking, earnings multiple for the current trading year to May 2022 is around 18, as I write. And that’s not a cheap valuation. I could come a cropper holding the stock if the company fails to make its earnings estimates.

But the balance sheet looks strong, so I’m inclined to add this stock to my portfolio with a five-year-plus holding period in mind. And while waiting for growth to unfold, I’ll collect the dividends and potentially roll them back into my investment.

The first stock to buy right now on my list is property franchisor group Belvoir (LSE: BLV). With evictions banned by the government and young people losing their jobs, I might assume the lettings agent would have seen rents drop. Yet it seems to have had a pretty good pandemic, with its franchisees continuing to do well, which bodes well longer term.

Belvoir provides both property sales and lettings, as well as financial services. Moving away from lettings, where it started, provides more diversified earnings. The expansion of financial services is particularly exciting. Also, Belvoir has formed some great partnerships, for example with The Nottingham Building Society. 

With a P/E of 12, the stock is fairly valued. Operating margins are high and the balance sheet looks strong. It’s all very positive. An added bonus is analysts forecast the share price rising by around 33%.

But as government takes tax breaks away from property investors, there might end up being less demand for Belvoir’s services. The property group is also acquisitive so there’s a risk it could overpay for future growth.

Overall through, I back management and the pandemic has shown the business model is resilient even in a difficult economic environment. I really do think it’s a stock to buy right now and will very likely add it to my portfolio soon.

Another high flyer

K3 Capital (LSE: K3C) is another stock with a lot to like, in my opinion. The Bolton-based business operates professional services businesses that advise SMEs. It has been growing revenue at a rate of knots. From 2015 to 2020 revenue more than tripled. It’s forecast to go from £15m in 2020 to £50.9m in 2022. That’s explosive growth, in my book.

Operating profit is also climbing strongly, margins are high and dividend growth is strong. With a market capitalisation of only £250m, there’s plenty of room for yet more growth.

With any share there is the possibility that the share price might not perform, of course. When it comes to K3 Capital, the main risks I see are that acquisitions may not integrate well or be too expensive. And as a professional group, people are key to its success so losing senior executives and managers could be a big blow.

Overall for me, the pluses massively outweigh the minuses. K3 is, for me, a stock to buy right now.

A final stock to buy right now

EKF Diagnostics is a final stock I want to briefly look at. The healthcare group grew revenues from £30m in 2015 to £65.3m in 2020. It’s projected to grow much further with revenues of £56.2m in 2022.

The risk with this one is the shares are potentially expensive with a P/E of around 29. But I’ll research further and potentially add to my portfolio as a riskier investment.

All these stocks strike me as high-quality growth opportunities. I won’t be at all surprised if they all see explosive growth in the coming months and years.

For investors, this economic growth could create a lot of lucrative opportunities. With that in mind, here’s a look at two UK shares I’d buy to benefit from a booming UK economy.

A disruptive company

One stock that could perform well as the UK economy recovers from Covid-19 is Keystone Law (LSE: KEYS). It’s an innovative platform-based law firm that’s disrupting the legal industry. Last year, it won ‘Law Firm of the Year’ at The Lawyer awards.

Demand for legal services is likely to rise as the UK economy picks up speed in the months ahead. In some areas of law, such as construction, employment and real estate, demand could rise significantly. This should benefit Keystone, pushing its revenues and profits higher.

In Keystone’s recent 2020 results, the company said that 2021 had “started well” with “good levels of activity.” It also announced a big increase in its dividend. This suggests to me the company is confident about the future. For the current financial year (ending 31 January 2022), City analysts expect revenue growth of around 14%.

It’s worth pointing out that Keystone is a small company. Currently, its market-cap is just £210m. Stocks of this size can be volatile. Another risk to consider is the valuation. Keystone’s forward-looking price-to-earnings (P/E) ratio of 40 doesn’t leave a huge margin of safety.

Overall however, I think the growth story here is attractive. I expect this company to do well as UK economic activity picks up.

This stock is flying 

Another UK stock I think could do well as the UK economy rebounds is K3 Capital (LSE: K3). It’s an under-the-radar business that provides advisory services to small- and medium-sized enterprises (SMEs). I expect demand for its services (which include company sales, off-market acquisitions, restructuring, tax planning etc) to be strong in the year ahead.

K3 appears to have a lot of momentum at present. In early March, the group said that following a strong start to the second half of its financial year, the group was trading ahead of expectations. In April, the group also advised this trend had continued, and said it expects results for the year ending 31 May to be “significantly ahead” of revised consensus market expectations. It now expects revenue for the year to be around £45m – much higher than the figure of £15m posted last year.

A key risk here is that the stock can be volatile at times. Early last year, for example, its share price halved. Sales can also be lumpy which isn’t ideal from an investment point of view.

Overall however, I think this stock has a lot of potential in the current environment. At the current valuation (forward-looking P/E ratio of 23) I think it’s priced to buy.

Purplebricks returns to profit

Purplebricks’ share price is up by 13% as I write, after the online estate agency reported a return to profit during the first half of the year. Management said the firm has seen “a strong market recovery”.

Although revenue fell 6% to £44.2m, Purplebricks reported a pre-tax profit for the half year of £4.3m. This compares to a loss of £2.3m for the same period last year. Adjusted profits for the full year are now expected to be ahead of broker forecasts.

Today’s results highlight some encouraging trends. Fee income rose by 6% to £49.1m. This was helped by an increase in the number of new instructions, which rose by 8% to 35,387. Average revenue per instruction rose by 3% to £1,392. This suggests that Purplebricks is not having to discount its services to win new business — good news for profits.

Purplebricks says that it now has 4.8% of the UK market and ended the half-year period with £75.8m of cash on hand. Investors are likely to view today’s results as a sign that this UK share’s growth story is back on track.

Profits flare at Chemring

Chemring’s share price is up by 12% to over 300p this morning, after the defence group reported full-year profits that were ahead of broker forecasts.

Sales rose by 20% to £402.5m during the year to 31 October. This lifted the group’s underlying pre-tax profit by 31% to £51.7m. Adjusted earnings per share climbed 35% to 15.1p, ahead of broker forecasts of 14p.

The company says that its businesses have remained open and fully operational this year, despite the impact of Covid-19. There’s been “good progress” with new orders for countermeasures, such as flares that are used as missile decoys. Recent contracts include a $107m order in Australia to support the F-35 Lightning combat aircraft.

Management said expectations for 2021 are unchanged. Chemring’s current order book covers 78% of 2021 forecast revenue, suggesting a fairly stable outlook for the year.

This UK share is rising fast

The share price of business broker K3 Capital is up by almost 10% as I write, after the firm said that trading was ahead of expectations during the six months to 30 November. As a result, management expects to report half-year revenue of £18m. That’s more than double last year’s half-year revenue of £8m.

K3 Capital’s share price has risen by 40% over the last six months. This AIM-listed company appears to be in a strong growth phase, which management said has been helped by the recent acquisition of insolvency specialist Quantuma. It added that the company has entered the second half of the year with “strong momentum”.

CEO John Rigby owns 11% of this £140m business, giving him plenty of skin in the game. Mr Rigby said that he’s continuing to look for new acquisition opportunities and is confident of further progress.

According to broker forecasts, K3 Capital’s earnings will be largely unchanged this year, before rising by 40% to 16p in the 2021/22 financial year. At current levels, that leaves this growth stock trading on 14 times 2021/22 forecast earnings.

Today, however, I’ll be looking at some of my worst selections for the year. Here are three of my worst tips in 2019 and some lessons we can learn from them.

Imperial Brands

Tobacco giant Imperial Brands (LSE: IMB) was undoubtedly my worst performer in 2019.

Throughout the year, I tipped the FTSE 100 stock on a number of occasions as it had fallen considerably and its valuation looked incredibly cheap (not to mention the 10%+ dividend yield on offer). At some stage, I expected IMB to rebound. But it didn’t. It just kept falling. If you’d bought in early April after I tipped it then, you’d now be sitting on a loss of around 35% (only 30% when you factor-in dividends).

To my mind, the biggest lesson here is that trends can last a lot longer than you expect them to. Imperial shares have been very cheap for a long time now as tobacco stocks have been out of favour. At the same time, results haven’t been that bad (the dividend was recently increased another 10%). But none of that has mattered. The trend here is down. Ultimately, going against a powerful trend is a dangerous move.

K3 Capital Group

Next up, K3 Capital Group (LSE: K3C), which is an under-the-radar business sales and brokerage firm. I tipped it as one of my top small-caps stocks for 2019 in early January. Since my tip, it has also fallen around 35% (not including dividends).

The reason I liked the look of K3C was that it had experienced significant growth in 2018. For the year ended 31 May 2018, revenue climbed 53% and earnings per share rose 114%. The company also released a bullish update in December 2018 in which it advised that it had a record pipeline.

Unfortunately, results in 2019 didn’t live up to expectations due to challenges associated with Brexit. For the year ending 31 May 2019, revenue declined 18% and earnings fell 34%. This resulted in the share price falling significantly during the year.

The lesson here is that it pays to be careful with businesses that generate a high level of non-recurring sales. Revenue can be lumpy. This can result in wild share price swings.

D4T4 Solutions

Finally, data specialist D4T4 Solutions, which I tipped on 21 May. Its share price has fallen around 23% since I tipped it.

I still like the look of this company as it’s very profitable and data is a high-growth industry. Yet like K3C, sales here are lumpy. Recent half-year results were quite underwhelming with revenue falling 37% on the prior year.

As with K3C, the lesson here is that focusing on companies with high levels of recurring revenue could be a better strategy. 

In conclusion, I’ll point out that losses are part of investing. No one gets 100% of their tips right. The most important thing is to learn from your mistakes so that you don’t make them again in the future.

Today, I want to share with you two of my top small-cap ideas for 2019. In my view, both have the potential to generate big gains for investors. 

K3 Capital

K3 Capital (LSE: K3C) is a leading business sales and brokerage firm that acts for businesses valued between £50,000 and £100m. The £120m market-cap company has recently won a number of industry awards, including first place in the 2017 Thomson Reuters Small-Cap Financial Advisory Review.

It first came to my attention in January last year when the group released an excellent set of interim results and its share price shot up above 400p. Since then, the shares have drifted back to 275p, yet the group has continued to make significant progress (full-year revenue was up 53%), which leads me to believe that the stock could be set for another leg up in the near future if results this year are robust. It’s worth noting that in December, the company advised that it had achieved “significant revenue and profit growth” across its Knightsbridge and KBS Corporate brands, compared to the first half of the prior financial year, which suggests to me that this year’s results could be good.

With the stock currently trading on a trailing P/E ratio of 19.6, I think there’s plenty of upside potential here. And with a dividend that is growing rapidly (the yield is around 4%), I also think K3C could turn out to be a cash cow for investors.

Gamma Communications

The next small-cap stock that I think has strong potential is Gamma Communications (LSE: GAMA). Founded in 2001, the company provides voice, data and mobile services for the business market, and its clients include Pret, British Heart Foundation, and Cathay Pacific.

AIM-listed Gamma first listed there in late 2014 at a price of 187p, and since then, the stock has risen to 800p, valuing the company at £716m. Yet the company is generating strong growth at present, and the shares don’t look particularly expensive, which leads me to believe that there could be more share price gains to come in the near future.

Crunching the numbers, there’s a lot I like about the firm. Revenue and profits are trending up at a rapid rate, and return on capital employed (ROCE) – a key measure of profitability – is high, averaging 27% over the last five years. Furthermore, debt is negligible, meaning the company is less vulnerable in the event of an economic downturn. Half-year numbers, released in September, were excellent, with revenue up 18% and cash generated from operations surging 66%.

With the stock trading on a forward P/E ratio of 22.9, I think the outlook over the medium term is exciting. 

Of course, smaller companies are more volatile than larger ones, meaning the risk of losing money is higher. Even the most promising smaller companies can experience setbacks and see their share prices fall significantly. Therefore, when investing in small-caps, it pays to diversify your money over a number of different picks, in order to lower your risk.

K3 Capital

K3 Capital (LSE: K3C) is a leading business sales and brokerage firm that acts for businesses valued between £50,000 and £100m. With a market cap of just £126m, this is certainly a small company, but given the speed the group is growing at, I think K3C has the potential to develop significantly in coming years.

Indeed, full-year results released last month demonstrated that the company has considerable momentum at present. For the year ending 31 May, group revenue rose 53%, earnings per share surged 114% and the full-year dividend payout was increased 56% – an impressive performance. Furthermore, the company advised that for FY2019, all three of its businesses have started the year strongly and that the group as a whole is “trading ahead of market expectations.”

K3C shares are up 83% over the last year, yet have pulled back around 25% since April to now trade on a trailing P/E ratio of 21.1. At that price, I think value is on offer.

Clipper Logistics

Another small-cap stock that I think warrants a closer look right now is £302m market cap Clipper Logistics (LSE: CLG). The company is an innovative logistics company that has grown significantly in recent years and counts Asos, John Lewis and Asda among its customers. 

While full-year results released in July looked quite robust with revenue rising 17.6% and earnings per share climbing 13.6%, investors dumped the stock after the company advised it was bringing “an element of caution” into its planning due to the wider forces affecting the UK retail sector. Yet I think the sell-off has been overdone, because top-tier directors have been loading up on shares recently, suggesting that they have confidence in the outlook.

At the current share price of 304p, Clipper trades on a forward P/E of 17.5 and offers a prospective yield of 3.3%. Those metrics look attractive, in my view.

Somero Enterprises

Lastly, check out £217m market cap Somero Enterprises (LSE: SOM), which produces laser-guided equipment that assists in the installation of concrete slabs, and has operations in the US, Europe, China, the Middle East and Australia.

Somero shares have had a good run recently and are up more than 20% since I last covered the company in 2017. But with the stock trading on a forward P/E of 13.8 at present, I believe there’s plenty more to come from this exciting smaller company.

Recent interim results certainly looked solid, with revenue rising 6%, cash flow from operations jumping 31% and diluted adjusted earnings per share surging 20%. A 100% increase in the interim dividend was another highlight. It’s also worth noting that Somero has practically no debt and has generated an average return on equity of 35% over the last three years.

Overall, I see a great deal of long-term potential in Somero Enterprises.