AIM’s boom and Best UK penny shares for 2018

If you want to go big in the stockmarket, you’ve got to go very small.

We’ve all heard of the shares that went from pennies to pounds. Well, the London Stock Exchange (LSE) has a special breeding ground for companies with this potential.

It’s called the Alternative Investment Market (AIM). And 2017 showed why you need to know about it.

The FTSE 100 and FTSE 350 indices spent 2017 going sideways, up less than 10% at the end of October. The large companies in these indices are sluggish, and so are their share prices. The FTSE AIM 100 index left them behind with an impressive 34% gain, more than three times the gain.

FTSE AIM 100 index leaves the FTSE 100 and FTSE 350 behind

FT chart AIm vs ftse 100 and ftse 350
Chart comparing AIM index (Blue) against FTSE 100 (Orange) and FTSE 350 (Brown). Source: Financial Times

There’s no doubt that AIM has been a huge success. Not only has the index surged, but the market developed and funded young companies, pushing the UK economy along.

Figuring out how well investors who buy AIM shares – commonly known as penny stocks or penny shares – have actually done is more complicated. But it’s well worth the effort, as it provides pointers on how to successfully gain exposure to the booming index.

First though, let’s look at…

Why do small companies boom?

There are all sorts of reasons why a smaller company can deliver the investment returns you dream of, leaving large companies in the dust.

The major reason is risk. A small company just getting started is more likely to fail than a large established one. The risk of failure is one many investors simply won’t take. Thanks to the lack of demand for their shares because of this risk aversion, small company share prices are lower to begin with. If they survive, the risk of failure falls over time, leading to less risk and a higher share price as more investors are willing to buy in.

The obvious example of this comes from fund managers. Many are simply not allowed to invest in small, risky companies. But as a company matures, if it survives, more and more fund managers are allowed to pile in. That helps keep the share price rising.

Of course, small companies have more potential to experience share price booms for the simple reason that their business can expand more too. They could go from serving thousands of customers to millions of them with the same product if that product is marketed correctly and withstands the test of time. Big companies tend to have saturated their market with their product, reducing growth potential for the business itself.

In the end, smaller companies simply offer more risk and more return. It’s a trade-off between the two. They key is to find a company that is mispriced. It is either less risky than others offering the same expected return, or it is offering more potential return for the same level of risk as others.

The best place to go looking for these companies is the AIM.

What is the AIM?

The Alternative Investment Market was launched on 19 June 1995. The objective was to attract small companies from around the world who needed access to capital to support growth. The index launched with just ten constituents – all homegrown – with total market value of £82m.

By February 2015, AIM UK boasted nearly 1,100 companies, including 217 from outside the UK. And over the past two decades, more than 3,000 companies have joined AIM at some point, raising more than £60bn in capital between them.

As it is the LSE’s entry-level platform, with a focus on small companies, AIM is often referred to as the “junior market”. More importantly for investors, it is also often described as “lightly regulated”. That’s because the admission requirements for companies wanting to list on AIM are far less onerous than for the main market, which serves larger, more established companies, such as those in the FTSE 100 or FTSE 350.

AIM’s different listing requirements

It’s worth investors being aware of these differences in listing requirements, as they have an impact on the type and quality of company attracted to the two markets and, by implication, the potential risk being taken on through investing in them.

For instance, to list on the main market a company needs to declare audited financial records for at least three years and be worth at least £700,000. With AIM, there is no such stock trading record requirement and no minimum market capitalisation. Also, with AIM-listed companies, shareholder approval is only needed for the largest transactions, and financial disclosure and reporting requirements are generally less demanding than for the main market.

Furthermore, while the main market demands that 25% of shares must be in public hands at flotation, there is no such requirement for AIM. That means if you hold AIM stocks with a very little liquidity (the ease with which shares can be bought or sold on the open market) you might have great difficulty selling them at a later date. That can be a big headache if the company disappoints for some reason – say it issues a profit warning – and you would like to sell quickly.

With all these potential drawbacks to investing in AIM stocks, it is not surprising that the junior market has a reputation for being risky for investors. Certainly there have been many sore disappointments over its 20-year history.

A few years ago, trading firm Banc De Binary revealed that 87 companies, or 8%, of the near-1,100 listed on AIM were members of “the 90% club”. That means their shares were worth just 10% of their peak value over the previous five years.

Forget index trackers, AIM is a stock picker’s market

Despite the immense risks, there are many good companies on AIM boasting good management, profitability and prospects.

Well-known success stories include the likes of stamp specialist Stanley Gibbons; wine retailer Majestic Wine; Domino’s Pizza (now on the main market); flooring group James Halstead; fashion retailer ASOS; and luxury handbag maker Mulberry.

So how can you benefit from these sorts of success stories? Well – much as we like them in many cases – the last thing to do is buy an index tracker fund.

Data put together by broker Hargreave Lansdown and Thomson Reuters for MoneyWeek in 2015 show that the FTSE AIM index, comprising all AIM stocks, delivered a total return loss of 17% since the index launched in 1997.

chart AIm vs ftse 100 and ftse 350

By contrast, the FTSE All-Share index, the most representative index of UK shares, reflecting nearly 1,000 companies, had returned a hearty 160% over the same period. And the total return from the FTSE 250 index between 1997 and 2015 (excluding investment trusts) is even more impressive at 520%. On the same basis the FTSE Small Cap index – comprising companies outside the FTSE 350 –  has generated a return of 178%.

The aggregate performance of AIM since its launch therefore can only be described as disastrous. So what happened in 2017?

The simple explanation is that AIM shares are vastly more volatile. During good times, they dramatically outperform the major markets. During bad times, they tumble far further. Over which period you choose to measure the returns determines the outcome, rather than the quality of the investment.

Just as important is the nature of the companies. Small businesses don’t have the survival rates of the large ones. Many AIM shares are trying to survive, not plod along. That’s what makes them cheap to invest in. And what gives you extraordinary returns when it works out.

For investors the big draw of buying AIM shares is that they hold the potential to grow extremely quickly compared to, say, much larger companies on the main market. Get it right, and investments can double, triple, or even more in relatively short periods of time. Imagine having bought into Microsoft or Apple when they were just geeky startup minnows.

But get it wrong and, as the members of the 90% club demonstrate, it can be painful.

AIM’s UK penny shares for 2018

For DIY investors, the AIM’s heady mix of the good, the bad and sometimes very ugly means it is a market that demands very careful analysis of companies, their balance sheets, quality of management and prospects, with regular reviews if chosen for portfolios. A healthy appetite for risk is an essential prerequisite.

Here are some AIM-listed companies you should keep your eye on:

Satellite Solutions Worldwide Group [LON:SAT] provides broadband-like internet to people who can’t access cable. For example, it just completed a project in Sør-Trøndelag, Norway, ahead of schedule. “The new network will service approximately 350 residential dwellings, 15 businesses along with around 500 holiday homes and cabins.”

The company is approaching 100,000 users, recently diversified internationally and turned a £500,000 loss into a £2m EBITDA (earnings before interest, taxation, depreciation and amortisation) thanks to major acquisitions. These threw out other financial indicators, but at around 7.5p per share, it’s a great price.

LightwaveRF [LON:LWRF] produces a selection of electronics components used in lighting, heating and electricity management such as dimmers, valves and sensors. Some are fairly sophisticated. It just raised £2m last year.

There is only a small amount of institutional ownership, which means less volatility for the stock from large shareholders buying and selling bigger packets of shares. Insiders hold more than a quarter of the company.

The EBITDA has steadily improved for four quarters, but the company is unlikely to be profitable soon. Lightwave has potential, but it’s struggling for now. The price is around 18.5p with an average daily volume of 87k shares.

AB Dynamics [LON:ABDP] is the motor world’s test provider. Many of the world’s major car companies use AB Dynamics products, plus the Williams F1 team. 95% of sales are outside the UK.

AB provides driver simulations, self-driver technology and testing equipment. The company is working to develop a system where the car self-drives if the driver experiences problems and just finished a new factory.

As self-driving cars become mainstream, governments will look to make their mark on safety standards. Any rules could turn AB Dynamics’ products into a mandated buy for major auto firms.

Liquidity in the stock is a problem, as it’s only small. And the last few years have seen the stock rise 200% already to £6.30. But the company is impressively stable for an AIM share, with a dividend and constant profitability.

Remember, these are highly speculative bets. Do not risk much of your capital in any one or even all of them.

In fact, there may be a better way altogether…

AIM shares suit some fund managers particularly well

Thanks to the heavy due-diligence required of AIM shares, the market seems to suit some fund managers particularly well. So it’s worth considering managed investment vehicles.

Giles Hargreave’s Marlborough UK Micro Cap Growth fund, for instance, has delivered a five-year annualised return of almost 20% according to Morningstar. The fund has had, on average, 60% of its portfolio exposed to AIM over its lifetime, though it has been as high as 78%.

Other funds worth considering if you are looking to gain exposure to AIM include Liontrust UK Smaller Companies, Old Mutual UK Mid Cap, Schroder UK Dynamic Smaller Companies, and several more. Be sure to research these carefully alongside any stock picks.

Read More: 8 Lithium Stocks you need to buy now

 

Category: Buying Aim Shares

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