Six tips for buying cheap AIM shares

Small companies, AIM shares in particular, appeared to be holding up reasonably well in the first few days of this year, despite the general collapse in share prices around the world. However, their performance has worsened as January progressed.

Larger, more liquid shares tend to fall first and their smaller counterparts can lag this decline, but they do normally catch up. Over a longer period, they can fall even further than larger companies.

I remember looking at share prices in the Financial Times after Black Monday in October 1987 - there was no internet then and most of the shares I owned were not on Ceefax - and feeling smug that they had hardly fallen in comparison with larger companies. Of course, it was not long before they started doing even worse.

The FTSE 100 index fell by 4.6% in the first week of 2015, whereas the FTSE AIM All-Share was only 2% lower over the same period. The following week, the FTSE 100 fell a further 1.8%, while AIM slumped by 3.8%.

The 7.5% decline in the FTSE 100 so far this month is already one of the worst performances for January in more than three decades. At one point, the index was down 9%, which meant that it was heading towards being the third-worst performance.

In nearly half the years where January has been in negative territory, the FTSE 100 has ended the year higher. Even in 2000, when January was down 9.6%, the year as a whole was only 10% lower.

AIM is just over 8% lower so far this year, whereas the FTSE All-Share index, which includes the FTSE 100 companies, is 7.8% adrift.

The size factor also appears true for AIM. The FTSE AIM 50 index is more than 10% lower, while the FTSE AIM 100 index is 9% lower. This is probably due to the more liquid, larger AIM companies being hit by selling first. Both the AIM 50 and AIM 100 significantly outperformed AIM as a whole last year.

It is noticeable how floorcoverings supplier James Halstead, soft drinks maker Nichols and light fittings supplier FW Thorpe, among others, have fallen more sharply than the AIM 50. That's despite them being steadier long-term performers on AIM whose share prices have more than doubled over a five-year period. These are easier to sell and there are profits to bank.

There are specific examples of companies where good news has meant that the share price has not fallen, such as Majestic Wine's Christmas trading statement.

There are six things to consider when thinking about existing or potential investments.

Risk

The first thing to remember is that the company needs to still be around to benefit from any recovery. This is not a good time to be investing in highly risky companies with weak balance sheets. If you want to take a chance on a high-risk company, there is nothing stopping you and there will probably be plenty of willing sellers.

This is doubly true of resources companies, where falling commodities prices are providing even more problems and making potential projects uneconomic.

Dilution

A company short of cash is not attractive at the moment, even if they can get additional funding. This is because any company that needs to raise money when share prices have slumped is going to have to endure heavy dilution, unless they have a good enough deal to persuade investors to buy additional shares at a premium to what is still likely to be a depressed price.

Potential dilution should be taken into account when decisions are made to invest in some small companies that will undoubtedly need additional cash to achieve their aims. This is effectively reducing the value of the existing shares.

A company with a strong balance sheet and no requirement for funding is a better bet.

Liquidity

Poor liquidity is a double-edged sword. When there is demand, the share price can be pushed up to ridiculous levels. However, limited liquidity can make it difficult to sell shares - and that is not just a problem for the sellers, it is also a problem for the holders when share prices dive on minimal trading activity.

The prices of these shares may barely change while larger, more liquid shares plummet, because there is no trading activity - but when someone does try to sell a few hundred shares, the price could slump. This happens in times of stronger stockmarkets and it is even more likely to happen in poor markets.

The trouble is that it will be difficult for existing shareholders to sell their shares unless they are willing to take a hit in terms of price.

Prospects

It is fair enough to invest on the back of the prospects for a company, but this is not a market that is going to give a heady valuation for potential in three or four years' time. If there is little or no profit at the moment, there is nothing to hold up a share price. It is different if a company has a track record of growing profit and that is set to continue.

This was not a good time for estate agency services provider Purplebricks to float when it has little in the way of revenues and makes significant losses. That is why the share price has fallen by more than one quarter from its 100p placing price at the end of 2015. Even at 74p a share, the company is valued at £178 million and the shares are trading on more than 10 times prospective earnings for the year to April 2018 - a forecast that appears optimistic.

High ratings

Even when companies are making profits, high ratings are unlikely to be maintained and there is more scope for their share prices to decline.

In a recent trading statement by EMIS, the healthcare IT provider admitted that the secondary care division had not done as well as expected, which led to a share price decline of nearly 16% in one day, even though overall trading was as expected. The shares are still trading on 18 times 2016 prospective earnings.

Even after its share price fall James Halstead is trading on 24 times prospective 2015-16 earnings.

The Fevertree Drinks share price continues to defy gravity, having dipped by a couple of percentage points so far this year. Fevertree has decent trading volumes and, while there have certainly been sellers, there have also been buyers to mop up the shares.

This shows that a lot of investors have a strong belief in the company, but any signs that the business is not going as well as expected could lead to a hit on the share price - particularly as the prospective profit multiple for 2016 is in the fourties.

Track record

In these times it is even more important to concentrate on companies that have a track record of performing to expectations. Anyone disappointing in these markets will be in trouble and the market will be slow to forgive them.

It is not a time to be investing in companies with "optimistic" management who are enthusiastic about their business, but rarely achieve expectations.

Two to consider

The flipside of these negatives is that they provide opportunities as well - but you have to be brave and recognise that there could be a lot to lose as well if you go for higher risk companies.

Good quality companies that may have been looking a bit toppy in the short-to-medium-term could fall back to more attractive levels. An example is transport optimisation software and services provider Tracsis, although the 2015-16 prospective multiple is still around 25.

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Motor dealer Vertu Motors has fallen by around 14% and it is trading on less than 12 times prospective 2015-16 earnings falling to just over ten in 2016-17. There is net cash in the balance sheet even after recent acquisitions. The car market remains strong and Vertu is growing organically as well as through acquisitions.

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One thing for sure is that you will not predict the exact day that the bottom of the market happens - unless you are very lucky. Once a market recovery does take hold, it will be the larger companies whose share prices tend to recover first.

Currently, focusing on quality companies that are profitable and cash generative is the most important thing. If a company is a good quality investment, its qualities will eventually be recognised.

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.