Around this time last year, the nation’s investment experts all started to point out how cheap the big FTSE 100 stocks looked and to suggest that we all switched out of smaller companies and into blue chips.
It wouldn’t have been a bad idea. In the last year, the junior Alternative Investment Market (Aim) index has fallen around 14 per cent while the FTSE 100 is down only 6.5 per cent. Admittedly, you’d have been better off in cash – you’d have made 5 per cent there. But, relatively speaking, at least the experts were right.
Now, however, it’s all the other way around. If you are looking for fundamentally cheap investments, you need to be looking at Aim where the average price-earnings (p/e) ratio has fallen to a mere 6.3 times.
There are 1,600 companies listed on this market, so there are obviously huge variations within this – miners and oil companies trading on p/e ratios of 20-plus and the odd outlier, such as fashion super-success ASOS (LON:ASC), trading on 40 times. Even so, talk to a small-cap fund manager of any kind, and he’ll be quick to point to a pile of favourite stocks all throwing off cash yet selling in the market for the bargain prices of 4r or 5 times earnings.
One example is AT Communications (LON:ATCG), a perfectly respectable telecoms company on a historic p/e of 5 times and a prospective p/e for 2008 of a mere 4.75 times.
So just why are there so many apparent bargains about? One answer might be, tax.
Until recently, capital gains on Aim-listed stocks were taxed at only 25% of the normal rate for higher-rate taxpayers, as long as you held the stocks for two years – so an effective rate of 25% of 40%, which is 10%. Now, however, you pay 18%, just like anyone investing anywhere else.
Then there is inheritance tax to consider. Certain Aim stocks are immune from inheritance tax. But now that couples are able to leave their nil-rate bands to each other (automatically combining their tax- free allowances) perhaps fewer people feel the need to bother with the kind of estate planning that Aim provides.
Of course, there is – as there should be – more to this than just tax. There’s also general risk-aversion. Smaller companies tend to be more geared to the domestic economy than larger multinational companies so, when things turn down, their shares inevitably suffer more than most.
And things are turning down in the UK – big time. The housing market gets worse by the day; there are signs unemployment is about to take a turn for the worse as jobs in construction and retail start to go; oil prices have now started to “melt up” – even more quickly than I suggested they would – and rising inflation means no interest rate cuts.
However, an annual survey of the market from Baker Tilly and Faegre & Benson, entitled “Taking Aim”, throws another kind of light on the way things have changed in the market.
Back in 2005, there were 335 initial public offerings (IPOs) on Aim, raising an average of £17m each. In 2007, there were 82, but the average amount raised was a massive £231m. In some ways, this might look like a good thing – more money was raised in total. But for real smaller companies it might not be.
Why? It suggests, says John Glencross of Calculus Capital, that the London Stock Exchange (LSE) and the companies that work as brokers to Aim-listed companies are more interested in marketing Aim as a home “to foreign companies seeking an international listing, where the amounts involved are very large, than to growing UK companies which typically want under £10m”. A number of last year’s listings were also large funds of one sort or another, or property-related companies.
For these overseas companies, and the brokers getting paid for bringing them to the market, Aim also presents an opportunity for a form of regulatory arbitrage. Its relatively light regulation and less-than-arduous listing requirements make it an easier place to get a fundraising away – and earn those commissions.
This makes sense, of course, in that both the LSE and the brokers are looking to make money, and you make more from big listings and secondary fundraisings than small. But it does make it hard for small companies to get their hands on funding.
This might be the key to the low-looking valuations. Right now, a small company, however good, doesn’t really have anywhere to go to get money to expand. The banks are closed or upping their rates; the debt markets have never been small-cap friendly; and if they only want a few million, Aim isn’t suiting them very well either.
At the same time, liquidity has disappeared from the market itself. Spreads are wide and volumes are low. So buying and selling stakes in listed companies has become little easier than buying and selling in private companies.
The combination of these two factors means that, right now, being listed on Aim isn’t really all that different to being a private company.
And what do private buyers pay for private companies? It depends on all sorts of issues but, in general, the answer is around five times profits. Look at it like this and maybe the seemingly cheap stocks rattling around Aim aren’t so cheap after all.
It would be nice if there were something to be done about all this – small companies are incredibly important to the UK economy. But, as it probably won’t be, I think we can expect the sector to continue to be starved of both funding and investor interest. Both are compelling reasons not to leap in just yet.
First published in the Financial Times