Why investors must beware fads and fashions on AIM

There tend to be fads and fashions in all stockmarkets, but they are particularly noticeable at the smaller end of the market. This is true of AIM, where there have been many fashions over more than two decades, and they have led to some initial strong performance followed in many cases by a sharp underperformance.

This has not just happened in the past few years. It was also true of the Unlisted Securities Market (USM). Back in the 1980s when electronics was a new, exciting area for the stockmarket any company that floated that could find an excuse would add electronics to its name.

Investors can be attracted to something new that they have not had the opportunity to invest in before or a sector where changes mean that growth should accelerate. PRs like to talk about companies "having a good story", but this is not necessarily the same as being a good investment.

The most obvious example is the number of internet companies that floated in 1999 and 2000 with barely a business model, let alone a business. Yet investors were willing to invest because they were led to believe that these would become large growth businesses and the share prices of the others already on the market were soaring. Of course, most of those companies are long gone and very few have prospered.

Once one company is successful, brokers start to look around for similar companies in the sector. Rival companies will also see their rivals getting a high rating and think they should have a similar valuation. The flotation of fishing tackle retailer Angling Direct a few weeks ago is an example of this.

Fishing Republic floated two years ago and has gained a high rating on the back of some of the high-profile investors it has attracted and the longer-term growth potential. Former Tesco boss Sir Terry Leahy and two others took a 15.9% stake. That led to the share price rising to a level where it is trading on more than 40 times prospective 2017 earnings.

Angling Direct raised cash at 64p a share and in a fortnight the share price has jumped to 93.5p. It may be a bit much to call this the start of a fashion, but it shows just how having one company valued at a high multiple can attract others with a similar business.

One thing to be aware of is that a sub-sector of companies may appear to have similar businesses but they do not necessarily have exactly the same - although when they floated they may have emphasised the similarity to attract investors. For example, although the businesses appear similar, Fishing Republic has much higher gross margins than Angling Direct.

One of the most disastrous fashions was football clubs. There was some logic behind the idea that rising TV revenues would benefit the clubs, but this did not turn them into profitable businesses. Manchester United is an exception and there do tend to be one or two companies that do prosper from an individual fashion; but most do not.

The other quoted football clubs either went bust, such as Leeds United and Leicester City; or just gave up on the stockmarket when their share prices crashed. Chelsea Village (Chelsea FC), of course, got taken over by Roman Abramovich.

It seems strange now that anyone could believe that football clubs would be money spinners for shareholders rather than footballers and their agents but that is why investors were attracted.

Few of the companies that ride the early growth in a fashionable sector will prosper over the long term. Management can believe that they are brilliant when they are one of the early entrants in a market, but once others move in they will need to be able to adapt. That is relatively rarely achieved by the incumbent management.

Consolidation is an exit route, but many companies hold on too long and are snapped up at a time of weakness.

Cleantech is another area where investors were attracted by an apparently exciting new market. There is undoubtedly growth in the sector, but many of the cleantech companies that floated on AIM were under capitalised and ended up running out of money.

At one stage there were dozens of cleantech businesses - 10 years ago - but there are currently little more than a handful of companies developing and using newer technologies.

There were eight fuel cell companies 11 years ago. Of those, ITM Power and Ceres Power are still on AIM and their share prices have each fallen by more than 90% over those 11 years.

They had risen from their flotation share prices but they are currently trading below even those levels. They have adapted their business models over time and both have made progress. This shows that getting in early is not always a good thing.

Fairpoint is arguably a company that has been exposed to two fashions. It started life as Debt Free Direct, the first individual voluntary arrangement (IVA) business to float on AIM.

Debt Free Direct was followed by Accuma, Debtmatters, Cleardebt and Invocas, which offered the Scottish version of IVAs.

These companies had a period of favour with investors, and rising share prices, but this soon went into reverse as creditors became less happy about the attractive deals for debtors and the fees achieved from IVAs. Competition had also increased and there was not enough profitable business to satisfy all the businesses.

The other IVA companies were taken over at a large discount to the flotation price, sold their IVA business or left AIM.

However, Fairpoint became a consolidator but knew its debt management and IVA operations were stagnating so it decided to move into legal services and become a major player in the UK market.

Changes to regulations that allow lawyers to become corporate entities enabled them to be acquired. Initial success turned into disappointing trading and a heavy debt burden that is difficult to service.

Gateley has done well since it floated and Gordon Dadds is reversing into AIM-quoted shell Work Group, with plans to become a consolidator in the legal services sector.

This brings to mind plans to consolidate the accountancy sector at the beginning of the century. Tenon, Vantis and Numerica all joined AIM with consolidation plans and the latter two ended up merging.

It may seem impossible not to make money from accountancy and lawyers but Tenon, later RSM Tenon, and Vantis both ended up going bust.

One of the problems that befell Tenon in particular was that it did not do enough consolidating its initial acquisitions and reducing operating costs. The high debt burden taken on proved too much when the business slumped into loss.

Mining as a sector is prone to going in and out of fashion. This is even more true when it comes to specific metals and metal groups. At the turn of the century tantalum explorers were in fashion because it was a commodity required for mobile phones. It is difficult to remember any major successes despite the apparent growing demand for tantalum.

These days it is lithium and cobalt that are the fashionable commodities. This is on the back of potential demand for battery technology used for electric vehicles.

It seems like most mining companies, whatever metals they previously focused on, are investing in lithium and cobalt projects.

For example, Greatland Gold, which has been focused on gold and nickel, is applying for cobalt exploration licences in Western Australia, while tungsten and gold explorer Thor Mining is taking a stake in a company that has interests in lithium projects in Arizona and New Mexico.

What these and other AIM companies' projects generally have in common is that they are early stage. Few are at an advanced stage of development.

One of the lessons to learn from these fashions is not to chase share prices upwards purely through fear of missing out on the next big thing. There will be other opportunities in the future and the next big thing is more than likely to prove a disappointment anyway.

Just because other investors are willing to buy shares at valuations that will not be justified for many years even if the expected progress is made - very rare in itself - does not mean that you should be buying.

Don't forget fundamentals and, if the company is unprofitable, think about what level of profit it might have to make in the future to warrant its valuation. Invest in the company not the fashion.