Nimmo explains how to make money on AIM

With its mixed track record, investing in AIM has recently been considered the territory of a madman, but can investors find value stocks despite recent poor performance?

If indices are anything to go by the Alternative Investment market (AIM) is a complete dead loss. The FTSE AIM index has fallen by around 32% in the period from launch on 1 January 1996 to July 2010.

Even the ‘blue chip’ FTSE 100 
index has managed a 44% gain over that period, while the RBS Hoare Govett Smaller Companies Index (HG) is up a more impressive 120%.

Ostensibly the HG and the AIM indices cover similar smaller companies: they are both exposed to growth markets; they both include companies in early stages of their development; and both have traditionally been fertile grounds for the new issues market. They feel almost interchangeable to fund managers who are active at the lower ends of the market, with many investing to a large extent in both indices.

In way of an illustration, I currently have around 20% – 13 individual holdings – of our smaller companies fund (OEIC) in AIM stocks. Am I mad? Given AIM’s track record, it looks like the easiest way of picking a pack of losers.

The birth of AIM

AIM was born out of the ashes of the Unlisted Securities Market. It is a place where the listing rules are more flexible; where lower standards of disclosure are required; and where it is cheaper to gain a quote, retain a quote and raise money.

It has also been viewed as a fertile ground for raising risk capital for smaller, riskier, nascent, growth businesses. Many AIM stocks may be little more than an idea, a technology, some drug research, some seismic survey results, some mining acreage in a far off land. Some examples of the oddest companies to raise money are listed below:

l Epitan – the ‘self-browning’ tanning implant with an associated sex-drive enhancing side effect.

l Subsea Resources – the world leader in raising treasure ships from the ocean floor.

l Nautilus Resources – another deep sea company involved in mining gold and copper nodules from the seabed.

l Aqua Bounty – a developer of transgenic fish, most notably the aqua-advantage salmon with added genetic material from the eel like ocean pout to help it grow quicker.

l Best of the Best – a lottery to win ‘supercars’ at airports.

AIM, in spite of its mixed track record, has certainly been a success story when it come to raising equity finance for the pointier end of the smaller development company market. Even after the setbacks of the dotcom bust and the 2007-08 bear market there are still 1,235 companies listed on AIM.

From pawnbrokers to pornography

You can invest in every conceivable sector from pawnbrokers to pornography. There are four individual ways to invest in oil and gas exploration in the Falklands Islands Basin alone. For example, Borders & Southern, Desire Petroleum, Falklands Oil & Gas and Rockhopper (or ‘Rockethopper’ as it is now known in dealing circles).

AIM is, however, subject to fads and is heavily exposed to development companies. Fully 70% of AIM listed companies generate no profits at all.

This has made the market at times very heavily skewed to hot sectors as they come into vogue, eg technology and the internet in 1999-2000, mining and oil and gas in 2005 and 2009 and real estate in 2007.

This has been the market’s downfall when these sectors turned sour. Today the AIM market is still heavily skewed to oil and gas and mining, together making up fully 34% of the whole market. Out of the top 50 largest stocks 26 are oil and gas or mining.

The issue is that investors underestimate the difficulty of turning an idea, a technology, some drilling rights, some drug research into an actual business with proper revenues, profits and even dividends.

Indeed 90% of them fail altogether. The AIM market is littered with the wrecks of companies that once looked so attractive – Clipper Windpower in alternative energy, Tanfield in electric vehicles, and Asia Energy in mining, to name but a few.

The latter underestimated fears of mass population relocation to make way for open cast coal mining at Phulbari in Bangladesh, with tragic consequences when demonstrators stormed their offices.

Nevertheless, I have found AIM to be a great place to generate returns for investors. Our largest two holdings are both AIM stocks – Asos, an online clothing retailer, and Abcam, an online distributor of antibodies.

Both have been in the portfolio for a number of years. Both have been strong performers. Andor Technologies, Craneware, Immunodiagnostic Systems Holdings, Kentz and Mulberry are others that have done well.

The difference is that they are all highly profitable businesses: they might well be mould-breaking ways of doing business, they may harness new technologies, they are all growing rapidly, and crucially they are all highly profitable and leaders in their fields.

They often have founders who are still in charge and are clearly entrepreneurial, but they also have what it takes to transform companies from start ups into profitable businesses. I have found that it is better to wait for the business model to be proven by the generation of profits, even if it means giving up a little of the upside from being involved at the earlier stages.

A casino?

Roel Campos, a senior official of Securities & Exchange Committee (SEC), is quoted as saying the AIM market ‘felt like a casino to me’ and that it ‘was a losing proposition to tout lower standards as a way to promote your markets’.

I would argue that the rate of failure is not that different to the fully listed market. In the last 10 years a depressingly long list of our largest-quoted companies have failed or been laid low, eg Marconi, Colt Telecom, RBS, HBOS, etc. This has occurred despite these companies enjoying the benefits that come from being listed on a fully regulated market.

The reality is that all stock markets are risky and therefore investors should stick to old-fashioned principles, preferring real businesses with revenues, profits and if possible dividends.

Harry Nimmo is manager of Standard Life UK Smaller Companies fund and Smaller Companies trust