While generally smaller companies have the ability to outperform larger ones over the longer term, investing in these firms is not a simple discipline. While the Alternative Investment Market (AIM) has thrown up some excellent companies, it’s also had its fair share of failures.
In fact, while the UK’s mid-cap index, the FTSE 250, has well outpaced the blue-chip FTSE 100, AIM has lagged. Since June 1, 1998, the FTSE 250 has grown almost sixfold compared with the FTSE 100, which has returned just shy of 150%. In contrast, the FTSE AIM All Share has grown just 10.72%, according to Morningstar Direct data.
But that’s been improving in recent years. Over a three-year period, the AIM All Share has doubled the return of the FTSE 250 and almost trebled that of the FTSE 100.
Success stories of recent years include tonic maker Fevertree Drinks (FEVR) and online shopping website Asos (ASC), which have elected to stay listed on AIM despite having become multi-billion-pound companies. Others that have graduated into the main market include takeaway pizza chain Domino’s (DOM), wholesaler Booker (BOK) and social homes maintenance provider Mears Group (MER).
The junior market has a low regulatory burden, so investing there can be risky. There are different ways to mitigate this risk, says Ken Wotton, manager of the LF Livingbridge UK Micro Cap Fund. One is through diversification. Some of Wotton’s peers have portfolios with between 100-300 holdings.
“I feel like you’re effectively buying the asset class if you’re investing in a portfolio of 150+ names,” says Wotton. “The other way to do it is to try and be really targeted about what you’re doing.” Playing to your strengths and investing in what you know is important, he adds.
Wotton says the fund, which has more than quadrupled investors' money since inception in 2009, has more analysts (50) than holdings (42), meaning his team can really get to know the companies and sectors in which they operate. “We’re not investing in companies we don’t believe in just because we want to make sure we don’t underperform the index. We only invest in businesses we genuinely believe are going to make money.”
That said, for retail investors, some kind of diversification will help to mitigate the risk of failed businesses impacting on the whole of your portfolios.
Inefficient Market
One benefit of investing in smaller companies as opposed to larger ones is that it can be an inefficient and under-researched market. Wotton says the average number of analysts covering stocks with a market cap below £250 million is around 1.3.
“If you do your research like a private equity investor would do, you might be able to spot some interesting or undervalued companies,” says Graham Bird, manager of Gresham House Strategic (GHS), an investment trust that says it takes a private equity approach to investing in the public market. It’s another with a concentrated portfolio, typically of between 10-15 companies.
Arbitrage opportunities can also throw themselves up because private equity investors tend to value things in different ways to public equity investors. One example Bird gives is with printing companies in the mid-2000s.
Then, private equity investors were buying these firms on seven times operating profit, but publicly listed ones were being valued at 4.5 times. In the end, “they all just got bought out by private equity and paid a premium”. “That’s a classic arbitrage closing.”
Profitable Companies
Both Bird and Wotton look for companies that are already making a profit. Cash flow and return on capital are important for both managers. That rules out a number of areas and Wotton says what you don’t invest in is almost, if not as, important as what you do invest in.
That screens out resources companies – miners, oil and gas explorers, etc, of which there are many in AIM – biotech firms and “loss-making”, or “bleeding-edge” tech outfits. “That means we might miss 10-bagger opportunities, but we’ll miss a lot of zeros as well,” says Wotton.
Wotton says AIM has been hurt over the years by “fads” like dotcom mania, oil and gas exploration businesses, gold miners and biotech. “These are very high risk and effectively their success hinges on binary outcomes.” Ruling these areas out takes the investible universe from around 1,300 to circa 700.
Wotton says his style would be characterised as growth at a reasonable price (GARP) with a quality overlay. Again, that rules out stocks on high valuations.
He looks for established companies with proven business models through different cycles. “Some of the companies we’ve backed over the long term went to the next level during the financial crisis because they were able to take advantage of other people not being able to operate effectively.”
These companies will be able to at least double their profits over the course of Wotton’s three to five-year investment horizon.
Quality Management
While Bird’s team works with firms to enhance their management and board, Wotton says he “places a big emphasis on the management team” to make the company a success.
“We’re much more about focusing on companies where the biggest risk is management execution risk, rather than does the oil price move against them or other big external factors outside of the control of management.”
Factors Wotton looks at here are the strength and experience the team has, their ability to articulate their strategy clearly and simply and whether they are incentivised correctly and have the right motivations.
Most of all, though, “you’ve got to be patient”, concludes Bird, “because you will go through bumps in the road along the way, just like with any small business”.
