‘AIM for Success’ Part 2: A blog by @AIM_Chaos

In the second part of @AIM_Chaos blog, he reveals more about his own investment strategy and also takes a look at the weird and wonderful world of company valuations on AIM.

It is very difficult to determine which is the product of the other, so for now I’ll simply say that going hand in hand with this extreme volatility is the sentiment-driven, short term mentality that is becoming increasingly synonymous with trading and investing on the AIM market in recent years.
On share forums and social media platforms one can observe retail investors watching wild share price movements amongst the small constituents of AIM, and wanting a piece of the action. Investors throw money into a company that is presently in vogue, seemingly having carried out next to no research on the business.

Whilst there are many full-time traders operating on AIM who employ technical analysis and follow stringent rules, for the average retail investor however the situation is quite different.

In the worst of instances, it can be as basic as ‘following the herd’ and buying into a share price simply because it is aggressively spiking. The punt is essentially a prayer that the company will keep enjoying the market’s blessing for a few more days or weeks, so that the share price continues to jump 10%+ a day, enabling the retail punter to exit at a healthy profit. Frequently however, this continued blessing does not occur. It may be that the company in question puts out a piece of news that is deemed ‘negative’ by the market, such as production figures coming in below market forecasts; or it may simply be that those investors who saw the wave of positive sentiment building in the company’s stock earlier on and bought in at lower prices have simply begun selling and are crashing the share price. The more recent investors then begin to sell too, compounding the fall of the share price.

With cheap online dealing platforms and easy access for the retail market to invest directly into individual companies, this environment on AIM is becoming ever more prevalent. On a weekly basis now, one can find a company putting out a statement that a regular investor in blue chip companies with no knowledge of the AIM market would consider to be slightly negative. As an example, let’s assume an oil explorer decided to delay the drilling of an exploratory well by three months. This delay might have a slight impact on cash flows – the regular blue chip investor might consequently expect a drop of a couple of percent in the company’s share price in question.

On AIM, such an announcement would invariably wipe off at least one third of the company’s market capitalisation in the first few hours of trading following the announcement.

There is of course a huge difference between trading AIM stocks and punting on AIM stocks. The former doesn’t necessarily require a great deal of knowledge on the company in question that is being traded, as long as a consistent strategy and discipline is maintained by the trader. The latter – the punter – seldom has a consistent strategy and discipline.

AIM has a number of core characteristics that shape the arena for investors and traders. To summarise, these are as follows:
– Limited institutional investment;
– Nomad-broker system;
– Lack of available independent research;
– Market makers and share price manipulation;
– Extreme share price volatility;
– Sentiment driven share prices;
– Short term outlooks.

As addendums to this list, we might include several more subjects:
– Incessant fears over future financing;
– Death spiral financing;
– Orchestrated share price pumping and dumping;
– Shorting and naked shorting;
– Online trolling to suppress share prices.

Again, as with market maker manipulation, each of these aforementioned topics are worthy of lengthy reports in their own right and I will not delve into them in detail at this point in time. In short, when all of these institutions, activities, psychologies and market mechanics coexist in one ecosystem – namely AIM – the effect is that the wider investment community treats this growth market with extreme caution. I have heard countless times investors and traders stating that AIM is not built for long term holds, owing to its casino-like nature.

However, for me, the highly flawed AIM ecosystem represents one thing above all: a marketplace that again and again offers exceptional investment opportunities for the astute investor.

For me, AIM is precisely built for long term investments. Sentiment driven stocks usually become quickly overpriced – that classic financial bubble diagram is illustrative of so many AIM stocks that have enjoyed and suffered it.
– The stealth phase;
– The awareness phase;
– The mania phase;
– The blow off phase.

If a trader / investor is able to catch a stock pre-mania phase, and exit his position pre-end-of-mania phase, all well and good. There are many exceptionally profitable traders who I have come to know in the AIM investment community. However, my observations lead me to believe that in the majority of cases, it is the professional traders who successfully execute this strategy, and in the large part retail investors who are caught holding stock during the blow off phase – or, to rephrase, who are caught holding stock when the share price is nose diving 25%+ a day.

So why do I believe that AIM offers exceptional investment opportunities? Well, taking all of the above into account, it is fairly straightforward to perceive that valuations of AIM-listed companies (and I am referring to the lower half of the market, those 500 or so with sub £20m market caps) are primarily driven by the retail market. This is not to say that the retail market is unable to value businesses accurately: rather it is that, generally speaking, the retail market has a shorter investment horizon that does the institutional market. Sentiment assumes a much, much more important role than does valuation analysis on the lower reaches of AIM. Take for example two FTSE 250 constituents – peers that operate in the same sector, in the same jurisdiction. The valuation discrepancy (using NTM PE ratio, for instance) between the two would very rarely exceed 20%. The market might pay a premium for one of the company’s stock owing to the higher quality of its revenues or cash generation compared to its peer.

On AIM however, the same scenario could result in a valuation discrepancy of several hundred percent. And fascinatingly, it is not uncommon that the fundamentally weaker company of the two attracts a valuation rating several times higher than its stronger counterpart. Why is this? There could be any number of factors at play that cause such a scenario. A frequently recurring factor is to do with the experience and/or character of the management teams in question. An experienced management team with a quality track record rightly attracts a premium valuation to the business that it is running; but on AIM, the premium can reach an absurdly high level. On a more cynical level, there are a number of well-known serial entrepreneurs/CEOs who operate on and around AIM: in some cases, one could classify the business qualities of these individuals as stock promoters primarily; as deal makers secondarily; and as business managers thirdly. They tend to attract substantial followings in the retail market, which results in huge liquidity in trading of the company’s stock.

Referencing this cynical outlook, on the other side of the coin are those businesses that trade at significant discounts to their peers. Most frequently it is the case that these businesses simply are not heavily promoted by their management teams / existing shareholders to the wider market, with less frequent news updates being released to the markets, and with less posting activity on online bulletin boards and social media outlets. As such, the names of these PLCs come into the sights of a smaller proportion of the retail investment community – thus inevitably less research is carried out on them, and ultimately there is less buying of their stock in the marketplace. Severely discounted valuations can also sometimes occur because a management team is in fact disliked by the retail community – most commonly owing to over promising and under delivering over an extended period of time, or else executing fundraises poorly. My largest loss to date was in fact the result of such a scenario: a nano-cap early stage base metals explorer had what I still believe to be a very exciting prospect,in an excellent jurisdiction. Unfortunately, the then management team both over promised and under delivered multiple times on numerous fronts, and sourced finance extremely inefficiently.

On a more general level, premium valuations for AIM-listed companies can simply arise from a lack of understanding of a company that has an unusual business model or has rare or unique exposure amongst its AIM peers to a certain subsector. This can result in a certain hype being built around the stock, on some occasions being as extreme as triple digit revenue growth for five straight years being priced in. Again, on the flip side, unique exposure can equally result in a suppressed valuation for a company (in comparison to sector peers listed on other exchanges such as the ASX or TSX), as the UK retail market struggles to evaluate companies without a suitably large peer group.

Each trader / investor should refine his or her own strategy. My own investment strategy is focussed predominantly on long term investing on AIM. There are several reasons for this, perhaps the most important being that I simply am not overly fond of (or, being honest, am just exceptionally average at!) short term trading.

Additionally, I find that I do have an edge over a number of other participants owing to my brief career as an equity analyst. To revert to the point made earlier in this note about the lack of quality independent research on companies in the lower tiers of AIM, I believe that there is a significant opportunity for identifying extraordinarily undervalued companies (notably in the nano-cap range) through relative and intrinsic valuation analysis. It’s about finding those stocks that are largely unnoticed by the wider retail market, or even unloved for whatever reason – stocks that are enduring massively suppressed valuations.

Usually I find that it is companies that operate in a niche industry, that the AIM investment community isn’t particularly interested in learning about; or companies that have seen completely over the top drops in their share prices over only mildly negative news that will not really have an effect on the business in the long term. The short term mentality of the majority of the AIM community results in monstrous overreactions, and thus we get some incredible valuation anomalies.

Once due diligence has been completed and a position has been taken in a stock enduring such a valuation anomaly, the key is having patience and sitting on one’s hands. Naturally, this is much easier said than done: it might be that the share price of the new investee company decreases a further 30% in the next six months as it drifts on no news (and this does happen – the short mindedness of many buy-side participants results in a steady trickle of selling, if the company does not provide regular updates on its operations). The crucial point at this juncture is not to bail at these fresh lows, assuming that one has miscalculated one’s entry level, and indeed doubting the entire original investment rationale. If the company’s story has not changed in the period or has actually improved, then it is imperative to stick by one’s guns and ride it through. The fundamentals of a company do shine through eventually. Negative sentiment can only suppress quality fundamentals for so long.

Part 3 of this blog will take a look at one such example of an investment that I hold that has experienced this sort of situation.

 

AIM Chaos is the research branch of a private investment vehicle named Sons of Ulster. Investment ideas shared are neither solicitations to buy nor offers to sell securities to 3rd parties.

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