The role of AIM stocks in tax mitigation is well-established; however, in recent years, with AIM impacted by broad disillusionment with the UK stock market, it has been harder to make the investment case. This has resulted in the valuations of many AIM companies hitting all-time lows, but there are several catalysts now evident that should help improve the performance of the index.
The UK’s smallest companies have been widely unloved. They have been on the front line of negative sentiment towards UK stocks and seen as more vulnerable to weakness in the domestic economy. They have been on the wrong end of a general flight to safety among investors. Rising interest rates have also been a headwind, with the valuations of smaller growth companies regarded as more sensitive to higher borrowing costs. However, markets tend to overshoot, and we see real value emerging today.
Operationally, many of the AIM businesses in which we invest have proved sound. They have continued to deliver strong growth despite a more difficult economic environment and have proved resilient in the face of higher interest rates. The combination of weaker share prices and stronger earnings has left many companies looking attractively valued, relative to their larger capitalisation peers.
A contributing factor has been a widespread misunderstanding of the relative risk of AIM companies. While there is certainly higher risk associated with speculative companies within the index, there are also plenty of well-established companies with strong business models, low debt and clear visibility on earnings.
An example of the latter is James Halstead, which manufactures and supplies flooring for commercial and domestic use. Its end markets include defensive sectors such as health and education, reducing exposure to the broader economic environment. It has cash on its balance sheet and the Halstead family still has a significant share of the ownership.
Valuations
Hardened investors understand that markets can often take time to reach a turning point and recognise that even cheap stocks can get cheaper before they recover.
The UK entered a technical recession at the end of 2023, which will do little to draw investors to its smaller quoted companies. Nevertheless – applying the caveat that stock picking rather than market timing is our strong suit – we are starting to see some green shoots.
While the economic environment remains lacklustre, it is slowly improving. Inflation has come down significantly and is likely to fall further over the next few months.
Previous peaks in inflation, such as those in 1975, 1980 and 1990, have been followed by remarkably strong performance from the UK’s smallest listed companies. In the three-year period following each of these peaks, total returns were 219%, 111% and 74%, respectively. (These statistics are based on the Deutsche Numis UK Smaller Companies index, the bottom 10% by size of listed companies, as it has a far longer track record than the AIM index.)
The Bank of England has hinted that rate cuts are on the horizon, even if it has been circumspect on the extent and timing of any cuts. AIM companies have shown inverse correlation with UK gilt yields; as interest rates rally, so gilt yields decline and the performance of the AIM index starts to revive.
We believe that as bond yields start to drop, it should help reverse some of the negative sentiment that has weakened the AIM market.
IPOs and M&A
There are also tentative signs of renewed optimism in the initial public offering (IPO) market. Last year was a fallow one for IPOs, but there have been encouraging signs of renewed activity over the past four months.
We've seen some interesting companies joining AIM; from disruptive fintech companies to England’s leading winemaker, which is starting to broaden our investment opportunities.
There has also been a revival in merger and acquisition (M&A) activity. While big deals such as those for Currys and Direct Line gather headlines, there is plenty of activity at the smaller end, with private equity and strategic acquirers buying up higher-quality companies at lower prices.
Political support
We also see a growing cross-party recognition that the UK isn’t doing enough to encourage investors to support British business. Most recently, this has been acknowledged by the introduction of a British ISA, which extended the tax-free allowance for investment in UK-listed companies.
There are also moves to encourage UK pension funds to invest more in UK equities (including AIM), starting with a disclosure regime. In the longer-term this may galvanise investment into smaller listed companies.
The recent rally may give a taste of things to come for the smaller end of the market. We believe a renewed optimism around the prospects for smaller companies will start to be reflected by the AIM index.
Of course, good stock selection is essential. The AIM index is a broad church, with a rich diversity of sectors and companies. Of the top 10 holdings in the index, only two are from the same sector.
The highest sector weighting in the index is in industrial goods and services at 15%, but technology (14%), consumer products and services (12%) and travel and leisure (10%) also make up a meaningful chunk of the companies.
There are over 650 companies currently listed on AIM, with up to £2.4bn in market capitalisation and many paying attractive and growing dividends.
There will always be companies that fail, or that struggle to manage costs effectively. However, careful stock selection can filter out the problematic companies, while focusing instead on those high-quality businesses with strong balance sheets and high returns on invested capital.
Overall, the quality of AIM stocks is as high as it has ever been, and we continue to find a wealth of choice for all our portfolios.
Simon Moon is co-manager of the Unicorn UK Smaller Companies fund. The views expressed above should not be taken as investment advice.