Will 2006 be a good year for small caps? And here’s another tough question: was 2005 a good year for small caps? Most commentators say that it was. Sure, the FTSE Small Cap index made 22%, a useful margin over the 17% rise of the FTSE 100 index. But those gains weren’t seen across the board: the much-trumpeted Aim market gained a feeble 4%.
How come? Well, for a start, a close look at the FTSE Small Cap index (supposed to represent the dynamic side of UK industry) reveals that its constituents include such unlikely representatives as the Martin Currie Pacific trust and the Schroder Japan Growth fund, not to mention the Edinburgh UK Tracker trust, which captures the performance of all the blue chips.
All the same, even stripping out the contribution of the investment trust sector, it is clear that the small company end of London’s main stockmarket has done a whole lot better than Aim. And that is a problem, because although Aim companies may be small, there are plenty of them. About 1,350, in fact, compared to the 300 or so companies in the FTSE Small Cap. And while institutional investors dominate the latter, Aim, with its attractive tax breaks, is recommended as the natural market for private investors.
But those same private investors are starting to question the claim of the London Stock Exchange (LSE) that Aim is ‘the most successful growth market in the world’. Growth of what, they ask? Not, it seems, the wealth of Aim investors. Instead, the LSE is referring to the number of companies quoted on Aim. A total of 494 companies joined Aim in 2005, and the newcomers have probably paid aggregate fees of around £100m to join the club. No wonder the City consider Aim to be a roaring success. It wants the gravy train to continue, and is already lining up a host of new entrants from as far afield as Russia and China.
Aim, though, may be suffering from its own popularity – and the resulting excess supply of shares listed on it. As anyone who has attended an economics lesson knows, prices do not rise when supply exceeds demand. And the favourable capital gains tax rules on Aim will be no use if there are no gains to be had. Investors will demand capital growth, and that means higher-quality new issues, and better returns from Aim companies.
Another popular explanation is that Aim firms generally have been tarred with the same brush as occasional spectacular failures, such as Regal Petroleum and Langbar. This explanation, too, is over-simplistic. Sure, companies that have run into difficulties have seen their share prices hammered. But those that have been able to deliver a stream of good news have rewarded shareholders. It is the middle ground that has suffered. Managers of firms that have been keeping their heads down, running their business effectively and quietly, have become frustrated by the lack of investor interest, and by the sight of their share price drifting lower through neglect alone.
I would pinpoint three reasons for the underperformance of Aim. First, it has become overcrowded. Unless they have a very hot story, good companies just cannot get the attention they deserve. Institutional fund managers do not buy shares in the secondary market, partly because the liquidity just isn’t there, but also because they are content to wait for the next placing of fresh equity, at a discount to the market price, to fall into their laps – a privilege not available to the poor private investor.
Second, the stockmarket was driven in 2005 by the voracious appetite of private equity funds for sizeable companies with reliable cash flows and marketable assets. There have been plenty such candidates among the established companies on the main list of the stock exchange, but very few on Aim.
And thirdly, as Charles Breese of Armshare.com has pointed out, “new issues are priced for perfection”. In other words, their pricing makes no allowance for the inevitable delays, hiccoughs and frustrations of smaller company life.
Where to buy shares in 2006: sectors
So what of 2006? There is no immediate sign of any change. Those whose job it is to write Aim prospectuses are as busy as ever, hyping up their client firms for all they are worth. And the private equity band-wagon seems, if anything, to be gathering pace. So good stock selection is critical. Firms operating in the following sectors should have the benefit of a following wind in 2006:
Oil services. It has taken time for big oil to dust off its project files and authorise exploration budgets. But, as Dennis Procter of oil service company Hunting Group said just before Christmas, “forecast demand is rising… and oil and gas companies are budgeting significant exploration and production increases”.
Security. This is another industry that takes time to crank up the volume. But after a long period of post-September 11th analysis, governments are now committing to projects to boost security, whether in the form of personal identification, airport screening or CCTV throughout the rail network.
Alternative energy. Rising prices and concerns over the security of oil and gas supplies are making it easy for firms to raise finance for projects either to produce alternative energy, or for its efficient use. There are several ways to play this theme. Companies such as Star Energy (STAR, 300p) and Egdon Resources (EDR, 125p) are developing subterranean gas stores, and Azure Dynamics (ADC, 54p) is developing hybrid engines, which, based on a combination of petrol and battery power, are finally becoming economically viable.
Technology. After the false bull market of the overhyped 1990s, tech firms are now starting to deliver strong earnings based on must-have products and sustainable business models. After the initial development costs, successful software firms delivering long-term repeat earnings are enticing.
With all this in mind, below are five Aim shares I think are worth buying for 2006.
Where to buy shares in 2006: the five best bets on the Aim market
Christie Group
Christie (CTG, 125p) is one of several firms to have chosen to cut costs by moving from the main market to Aim in 2005 – to the consternation of private investors, who can no longer hold the shares in their Isas. Dating from 1935, it is a well-established firm with two strong and reliable divisions – professional business services, which provides advice to small businesses, particularly on transaction valuations, and stock and inventory services, which basically means checking how many bottles of beer are left on the pub shelves at the end of the week.
Between them, these made an operating profit of £5.2m in the latest 12-month period, and since Christie is virtually debt-free, this would easily support its £32m market capitalisation. However, the third division, software solutions, which provides point-of-sale software to retailers, has run up losses of £4.7m in the last three years, letting the side down badly. But this division’s turnover has continued to grow over the period, so the problem is not to do with sales. Rather, it has been the £2m per year that Christie has spent perfecting a new retail software package code named Magellan. This will be launched this year, and will be one of the best products on the market. It will boost sales and will mean that Christie can reduce its development spending. Together, these factors could provide a £3m boost to Christie’s bottom line in 2007.
Computer Software Group
Take the fast growth of successful software providers and a smart cookie who knows how to find and acquire such companies at knock-down prices. Put this on a p/e ratio of just eight, and you surely have a candidate for 2006’s best-performing share. The power behind Computer Software Group (CSW, 71p) is chief executive Vin Murria, a pocket dynamo who is building the group through a series of shrewd and highly successful acquisitions. The latest, Transoft, was bought for £3.7m – but is expected to make an operating profit of £1.5m in its first full year. Computer Software Group is targeting niche sectors, such as charities, and is managing to cross-sell products, such as client-relationship management programmes, across its client base. Of its revenue, 80% is recurring, and Computer Software, which is valued at just £34m, is generating about £4m of free cash annually. Profit forecasts were raised after November’s excellent interim results, and Murria is eyeing larger deals for 2006, which should put these very cheap shares under the spotlight.
Colliers CRE
Two of the top-performing small company shares in 2005 have been property agents Savills and DTZ. And no wonder. Not only has demand for property in the key London market been picking up, but global property investors have started to look beyond their domestic boundaries and seek out higher returns abroad. For that, they need advice, and British companies are among the top international names in this business. There is little competition from the continent, where commercial agents have traditionally restricted their activity to transaction brokerage, and the Colliers CRE (COL, 157p) network of 248 offices in 51 countries is the second-largest in the world behind CB Richard Ellis.
Yet shares in Colliers CRE have made little progress over the last 18 months. Admittedly, shareholders only own the UK business, not the affiliated global network, but still, business is booming. And acting as an adviser, a direct investor into property, and as manager of the best-performing property fund of the last ten years, Colliers CRE has several fingers in the pie. Management has been busy moving into a new head office, integrating recent acquisitions, such as Gooch Webster and Fletcher King, and updating its IT systems. Now it is ready to raise its profile, and with earnings per share of 16p, the shares are at a discount of about 30% to its UK rivals and look good value.
European Minerals
European Minerals (EUM, 50p) is a mining stock that ticks all the boxes. Its project at Varvarinskoye in northern Kazakhstan has proven reserves of 1.94 million ounces of gold and 238 million pounds of copper. This is an open pit with none of the perils of underground mining. Construction of the site is well underway, at a fixed cost of £71m, and with the main Russia-China railway within 14 kms, logistics pose no problem. Construction has been financed by £28m of equity and a £42m loan, repayable over eight years. In the first ten years of its anticipated 15 year life, the mine is expected to produce 1.45 million ounces of gold at an average production cost (reduced by a credit for copper production) of $130/oz. To cover the loan repayment, 443,000 oz of this has already been sold forward at a price of $574/oz. Adding the remaining 1.07 million oz at today’s gold price of $530m, and total gold production in the first ten years nets £357m. Assuming full exercise of the 83 million warrants (exercisable at 58p per share), European Minerals would have issued 279 million shares, valuing it at £144m. Production is scheduled to start in the fourth quarter, and I expect the shares to advance as that date gets closer.
ServicePower Technologies
ServicePower (SVR, 34p) seems to be on the threshold of software’s holy grail – repeat fees on high-volume transactions conducted over its proprietary software. The business has made slow progress since its Aim debut in 2000, but while it has kept a low City profile, management has been busy building the business in the USA – where it has signed up General Electric and Siemens to its field-scheduling software. This automatically schedules the appointment of field servicemen, adjusting them throughout the day as jobs are completed or delayed by traffic hold-ups.
In 2004, ServicePower changed its business model from only selling software packages and began to take over the task of managing teams of servicemen and processing work and payments. Recently, it launched ‘FSS In A Box’, a service that enables it to despatch job instructions to independent servicemen, complete with GPS tracking, journey directions, and credit-card processing – all delivered via the engineers’ mobile handset.
Last year, ServicePower announced a string of new contracts, including one for a large firm of auto-loss adjusters, and another for Echostar, whose service team installs satellite TV. Based on such prospects for long-term recurring revenue, brokers are forecasting a five-fold increase in sales from £4m in 2004 to £20m in 2007, when earnings per share would exceed 4p.
Tom Bulford is the editor of the Red Hot Penny Shares newsletter.
Investing in shares can lose you some or all of your investment. Never risk more than you can afford to lose. Small company shares can be illiquid and carry higher risk than other shares. Past performance is no guide to the future. Consult a financial advisor if unsure. Fleet Street Publications Ltd. 020 7633 3600