The launch of the Alternative Investment Market (AIM) in 1995 was an innovative attempt to expand the listing of higher growth companies. With the provision of lighter touch regulation, it made it easier – and cheaper – for firms deemed higher risk to raise capital in the public markets.
Many fund managers regarded the market with suspicion in the early years, believing it was dominated by esoteric mining names or low-quality, founder-dominated businesses. Several scandals did nothing to dissuade these beliefs.
The last few years have seen a renaissance in market perception. AIM is now clearly the home for individual investors and fund managers to find the next interesting growth companies. There are now over 950 listed stocks, with an average market capitalisation of over £100m. About £108bn of funding has been raised over the market’s 22-year life. Moreover, there are added tax advantages for private investors, with qualifying shares free of inheritance tax.
IPOs lead the AIM renaissance
The renaissance has been led by a surge in IPOs to AIM, with high-quality smaller company managements looking to access the flexibility and tax advantages the market offers – particularly for owners with significant stakes.
Interestingly, many of the AIM success stories – such as online retailer ASOS – have not graduated as expected up to the main list, despite carrying market capitalisations worthy of entering the FTSE 100.
Clearly, AIM stocks still require higher levels of due diligence for investors than those on the main list. Corporate governance standards, for example, vary enormously. We avoid investing in small mining companies, as we deem them speculative rolls of the dice, rather than real investments. This helps eliminate many of the lower quality and risk-laden businesses. Extensive due diligence through company visits and talking to competitors is now more important than ever in terms of risk management.
Uncovering hidden gems
We believe smaller companies remain a substantial opportunity to gain alpha, given their often-undiscovered status and growth potential. Currently, about 19% of our EdenTree UK Equity Growth Fund is in AIM stocks – which is roughly 70% of our total small-cap exposure. As well as higher-profile success stories, such as soft drinks mixer maker Fever-Tree or software company Blue Prism, we have recently taken positions in a number of other interesting under-the-radar stocks.
For example, £190m business services company Marlowe is rapidly acquiring companies across a range of critical testing services – such as fire, security, water and air – which can be cross-sold to customers. Possessing a highly-regarded management team, Marlowe at the beginning of building a substantial business.
Meanwhile, Globaldata is a £700m provider of research and consulting solutions, which packages its data to healthcare and consumer markets. It was founded and is majority owned by Mike Danson, who built up and sold Datamonitor to Informa for £500m. Strong underlying market growth is being complemented by operational leverage, as margins move to industry levels, and by further acquisitions in adjacent verticals.
While the stock appears expensive, it is worth remembering Globaldata is in a growth phase. The group’s current operating margins are about 20%, compared to more than 30% for other high-data centric businesses delivering. This is a realistic medium-term target for Globaldata, as it leverages its data into new products on a largely fixed-cost base. The recent acquisition of Research Views temporarily raised Globaldata’s debt, but this should fall rapidly given the group’s highly cash generative nature.
Another attractive under-the-radar example is Morses Club, the number two in the home collected loan market. The company, which has a 16% market share, has benefitted from the missteps of market leader Provident Financial and picked up a number of experienced agents. The company is a classic cash compounder in an unloved market, with an RoE in excess of 20%, despite a significantly under-levered balance sheet. The company could continue to drive returns higher, as it modestly gears up and takes advantage of current regulatory uncertainty to buy smaller competitors struggling to gain authorisation.
The final attractive stock we have recently picked up is Sumo, a market-leading independent video games developer. Sumo has excellent long-term relationships with the world’s largest publishers, such as Microsoft and Sony, which are increasingly outsourcing important aspects of key titles to the company. Given the multi-year nature of title development, there is a high degree of order book visibility. Sumo’s margins are high, and it has excellent cash flows levels derived from the client base.
In addition, by growing employee numbers, Sumo Group will overcome its greatest current constraint on growth. Further growth will come from taking royalties on games and risk sharing with clients, rather than standard contract terms. It also produces a limited number of its own games to maintain low-staff attrition rates, offering a financial upside in games developed. A strong balance sheet gives Sumo the opportunity to deepen relationships with customers by acquiring and providing further complementary services.
In each case, there was not much research available on the respective companies. Only by taking the time to visit company management and undertaking significant due diligence could these interesting growth opportunities be unlocked as investments. Greater reward means greater risk, but the potential of the AIM is now being realised.
Phil Harris, portfolio manager of the EdenTree UK Equity Growth Fund