How to play the Alternative Investment Market
8th April 2016 17:24
by David Budworth from interactive investor
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Look at the list of best-performing shares on the Alternative Investment Market (AIM) over the past year, and you'll find more than a few surprises.
Most people assume all mining stocks have been battered by the collapse in commodity prices, and that it has been wise to steer clear of the biotech sector since share prices tumbled last September (following presidential hopeful Hillary Clinton's tweet threatening to cap prescription drug bills).
So it is something of a shock to see that the biggest riser on the (over the 12 months to 8 March) has been a company that invests in the natural resources and energy sectors: , up 767%.
In second place comes , the oil and gas exploration company, shares in which have risen in price by 667%. In 17th place sits (up 168%), which is at the forefront of biological developments to fight obesity, high cholesterol and diabetes.
Sturdy performers
These sturdy performers are not alone, as 43 stocks on London's junior market have at least doubled in value over the past year, including a fair smattering of companies in the otherwise poorly performing mining and biotech arenas.
It is a demonstration of why you should never take things for granted on AIM. Set up in 1995, the market allows small and growing companies to raise finance under less onerous, lower-cost listing rules.
AIM has come a long way since it launched 20 years ago, when it hosted 10 companies with a combined market value of £82 million. Now it is home to just over 1,000 companies in more than 100 countries, including household names such as model train maker , luxury goods group and polling agency .
The image of AIM as a market solely for small and fledgling companies is dispelled by the size of some of its biggest constituents. , the online fashion retailer that listed on AIM in 2001, has a market cap of £2.4 billion. Were it to seek a main market listing, it would slot comfortably into the FTSE 250 index of medium-sized companies.
Not that the past two decades have all been about growth - far from it. Investors have endured plenty of thrills and spills since AIM's launch, including a fair number of corporate blowouts and fraud cases.
Overall returns have been poor: during the past 20 years, the AIM All-Share index has generated an annualised return, excluding dividends, of -1.7% a year, against a 3.5% return from and 5.0% from the FTSE Small Cap index.
However, as the stellar returns from the stocks mentioned earlier demonstrate, focusing on the index does not give a true picture of what is going on at the company level. It is a great market for making money - if you can pick the right stocks. So what is the secret to success when investing on AIM?
Don't rush into AIM
Rush into AIM at your peril. Much of the market is still comprised of small, unproven companies with market capitalisations of less than £100 million. Many of these firms will fail to meet ambitious growth expectations and come crashing back to earth.
Research conducted last summer by professors Elroy Dimson and Paul Marsh at the London Business School found that over the past 20 years, investors would have lost money in 72% of all the companies ever to have listed on AIM.
Some 201 stocks listed on the AIM All-Share index have lost half or more of their value over the past year (12 months to 26 February), demonstrating the dangers that lurk in AIM.
The junior market has been criticised over the years for its lax listing rules, which some argue fail to screen out companies with little chance of longer-term survival. In 2007 John Thain, head of the New York Stock Exchange, said AIM "did not have any standards at all and anyone could list".
Sour grapes, perhaps, because at the time the London market was winning the battle to attract overseas companies. However, scandals linked to poor corporate governance are not uncommon among AIM companies.
The Serious Fraud Office opened a criminal investigation into the "business and accounting practices" of insurance software group Quindell in August last year. The investigation is ongoing. Meanwhile, the company, which was suspended from trading, has simply re-listed as .
The management standards of Chinese companies on the market have also been under scrutiny after a number of them, including footwear business and food additives group , delisted or had their operations or shares suspended last year. This left investors holding worthless share certificates.
'Nomad' protection
The London Stock Exchange argues that protection is provided by nominated advisers, called "nomads", who are there to police the market. Each company listed on AIM must employ a nomad to ensure its corporate governance is up to scratch.
Some of the Chinese de-listings were triggered when nomads withdrew their support and refused to act for firms any more. , the cash-strapped Glasgow-based football club, was dumped by its nomad last year with no one willing to take the club on.
Investors still need to take extreme care: those same nomads, usually investment banks or stock brokers, may only a few years earlier have been enthusiastic supporters of the companies that subsequently left investors high and dry. Some of the smaller AIM stocks also suffer from a lack of liquidity (they are difficult to sell when you want to head for the exit).
With so many AIM companies at risk of failing, the odds of success are stacked against AIM investors. However, some of the UK's most celebrated fund managers, including Neil Woodford and Gervais Williams, view AIM as a fertile hunting ground.
Williams, who has invested about a third of his in AIM, argues that it is a good market to be in right now. He contends that, contrary to popular opinion, smaller companies are a safer place to invest than large ones when markets are unsettled, as AIM-listed companies can grow even when the economy is not growing.
"Most smaller companies have less to do with China and can continue to invest capital for productivity improvements at a time when larger companies are struggling to invest for productivity gain," he says.
But, how do you gauge a firm's worth? "It is important to not just focus on the bottom line," says Williams. "You want companies with enough cash to be able to grow their dividends in three or four years' time."
Cash flow importance
Phil Oakley, a commentator on the investment website ShareScope, agrees that one big mistake investors make when looking at AIM stocks is to place too much importance on company profits. A seemingly profitable company trading on a very low multiple of profits, as measured by the price/earnings ratio, should set alarm bells ringing.
Oakley says: "It is like when you come across a second-hand car with very low mileage for its age. If it seems too good to be true, it usually is. When it comes to looking under the bonnet of companies, you won't find the answers looking at their profits. If you want to get closer to the truth, you need to study their cash flow performance."
Cash flow is the amount of cash left over from profits to pay shareholders. Cash-generative companies might be worth investing in, while a lack of cash flow over several years could be a sign of danger. Currently, the most cash-generative businesses on AIM include technology company , the online trading group and commodities company .
Mike Stoddart at private bank Brown Shipley, which specialises in building AIM portfolios to reduce inheritance tax, says it is important to be sure of what to avoid. His team steers clear of start-up companies, illiquid companies worth less than £40 million, and sectors - including biotech, oil, and gas and mining - where the fate of a company is often out of management's hands. Biotech stocks, for example, are at the mercy of regulators, and mining stocks in the thrall of global commodity prices.
Stoddart says: "We take a conservative approach. We look for companies that have a stable business profile and are able to demonstrate good financial performance, and where returns to shareholders have been good."
Managers who buy AIM stocks usually run very diversified portfolios, knowing that even well-managed, cash-generative businesses are vulnerable to nasty shocks. Financial advisers usually recommend that you commit no more than 5% of your portfolio to AIM shares if investing directly.
A number of wealth managers, including Brown Shipley, Investec Wealth & Investment and Killik & Co, will create AIM portfolios for you, usually as a means of minimising inheritance tax. Such schemes invest in a portfolio of stocks, typically between 15 and 30, and tend to pick from the less risky end of the AIM spectrum. To ensure the portfolios are properly diversified, Killik and Investec have minimum investments of £50,000 while Brown Shipley insists on £100,000.
A collective fund run by a professional manager is an alternative way to get exposure to the junior market. The only fund dedicated to the market is , but many smaller company and multi-cap funds invest in AIM.
The financial crisis and its aftermath have led to a shakeout on AIM. In 2007 nearly 1,700 companies were listed on the market, but this has shrunk to 1,031 - although they are still collectively valued at £68 billion. The number of companies seeking admission to AIM has also declined from a peak of 519 in 2005 to 61 last year.
However, it is still an exciting place to invest, according to Stuart Andrews, at broker FinnCap. He says: "There are more decent tech stocks listed on AIM than on the main market, a burgeoning consumer sector with the likes of [the maker of premium tonic water] and lots of interest in the financial services sub-sector.
"Equity markets are not particularly conducive to listings at the moment, but AIM companies are not moving to the main market. They have no desire to change something that works. AIM is going to be around for a long time."
The tax advantages of AIM holdings
The attractive tax treatment of AIM shares can make the associated risks more palatable. There is no stamp duty to pay on purchase, as there is with mainstream shares.
AIM shares can now be held within an ISA, which enables investors to benefit from tax-free growth. Many AIM shares qualify as business assets.
Once they have been held for two years, they no longer form part of an individual's estate for inheritance tax purposes. This is known as business property relief (BPR). It can make AIM shares a very useful estate planning vehicle.
Do all AIM shares qualify for BPR?
Many do. However, the tax break does not extend to most property, finance or mining and exploration companies. Investors Champion has a search tool that lists AIM companies that may qualify for BPR, but the important word here is "may," as the list is not an official one.
To benefit from BPR, you have to invest in the shares directly. The IHT perk is not normally available to funds. However, discretionary portfolios selected on your behalf by wealth managers and marketed as AIM IHT portfolios do qualify.
Are there any other tax breaks available?
You may also be able to invest in AIM companies in a tax-efficient way through venture capital trusts or enterprise investment schemes.
Two funds for the AIM investor
Adrian Lowcock, head of investing at Axa Wealth, likes the fund, which has around two-thirds of its money in AIM stocks.
He says: "Giles Hargreave is an exceptional long-term manager who conducts thorough, detailed company analysis and combines that with a strict portfolio construction discipline.
"Holdings are initially quite small and only added to when they show progress. Investments that underperform and don't meet expectations are quickly sold."
He also tips , which focuses on firms with a market cap of less than £100 million, and invests on AIM and the main market.
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.