Should you invest in the AIM market?

AIM is a wonderful market for making money: just look at Western Coal, whose shares have all but quadrupled, or IQE, which has trebled over the last year.

But AIM has also been a disaster in which investors have lost billions: just look at Desire Petroleum, whose shares stand at just a fifth of last year's peak after the oil it thought it had discovered turned out to be water; or Madagascar Oil, worth more than £150 million last year, but whose shares are now suspended on fears its licenses could be seized by the country's government.

That neatly sums up the Alternative Investment Market, to give it its proper name: while it is possible to make significant sums by investing in the kind of small growth companies that make up the bulk of its components, there is a significant risk that investors could lose most, or even all, of their money.

Split personality market

This split personality is also evident in the overall performance of the market. Last year was a very good one: the return on AIM was 44%, well ahead of the 30% return on the FTSE All-Share index or the 26% return on the RBS Hoare Govett Small Companies index, the most widely followed small company index.

Over the 15 years of its existence, however, performance is pretty dismal. In the latest edition of the RBS HGSC Index Report, authors Elroy Dimson and Paul Marsh calculate that over the 14 years from 1997, £100 invested in AIM would have declined to £96, while the same invested in the HGSC index would have grown to £298.

That is largely due to abysmal performance in 2008, when AIM lost 60% of its value amid a series of scandals and disasters - Regal Petroleum, which was reprimanded by the stock exchange for "systematic" breaches of rules, is one of the more colourful - which saw it labelled a "casino" and criticised for the poor quality of companies allowed to list there.

It is certainly a far less rigorous market than the main stock exchange. It operates under a "comply or explain" basis, has few concrete rules on things such as minimum trading history, market capitalisation or proportion of shares which have to be publicly traded.

Instead, it relies on a system of nominated advisers, or nomads, whose job is to ensure the probity of the companies which they take to market. A review of AIM's performance did result in the introduction of a regulatory handbook for nomads, but investors say there is still a considerable variation in their quality.

"It is important that you deal only with those you trust," says Harry Nimmo, manager of the Standard Life UK Smaller Companies unit trust and investment trust.

He is, however, a big fan of AIM, which accounts for around a quarter of his fund and two of the top three shares in his portfolio. "A lot of money has been raised for growth companies [on AIM]. There is nothing else like it in the world," he says.

He follows a number of simple rules: he does not invest in companies with a market value of less than £400 million, whether on AIM or the main market, and he avoids "conceptual" or "blue-sky" shares, whose future depends on the success of their technological innovation or new wonder drug.

Nimmo explains: "I feel investors underestimate the difficulty of turning a new technology or idea into a proper product."

Avoiding the very small companies does rule out a large chunk of AIM. The latest statistics on the market show that just 78 of the 1,182 companies quoted are valued at £250 million or more, although that accounts for more than half the index's value.

And there are some very large companies: Nimmo's own favourite, internet retailer ASOS, is the sixth largest at £1.1 billion and the largest, Western Coal - which has just agreed a merger with Walter Energy and so is leaving AIM - is worth more than £2.1 billion, which would put it well into the top half of the FTSE 350 index were it quoted on the main market.

The resources sector

Investing in AIM does require taking a view on the resources sector: it accounts for eight of the top 10 by market value and around half of the total.

Indeed, it was the dramatic recovery in resources stocks as prices of numerous commodities rose to new highs that powered last year's performance: Dimson and Marsh calculate that, excluding resources, the return on AIM was 22.6%, compared with 24.8% for the HGSC index.

It is this preponderance of resources stocks - many of them high-risk, loss-making explorers based in small, unregulated, emerging markets - that has given the market its casino reputation.

But Mike Prentis, manager of BlackRock Smaller Companies and Throgmorton investment trusts, says there are plenty of reputable and profitable shares to choose from across most sectors. He cites Abcam, Immunodiagnostic Systems and Gooch and Housego as AIM-listed high-quality, global, technology-led companies that are growing profits strongly.

He also points out that many resources stocks are highly profitable and cash generative. Eastern Platinum and Avocet Mining, good performers that continue to show production and profit growth, are held in his portfolios.

His BlackRock trust has around 40% of its portfolio in AIM, but the tests for portfolio inclusion are the same as for fully-listed companies, with the focus on fundamentally strong, profitable, cash-generative companies.

And as with fully-listed holdings, some AIM holdings do succumb to takeovers, such as former top 10 holding Western Coal, or move on to a full quote, such as City of London Investment Group. "If they do move up to the main market, they lose some of the flexibility to do merger and acquisition transactions quickly and cheaply," says Prentis.

"Some companies regard this as an important advantage of being on AIM, but we debate with companies why they want this flexibility. We do not invest in companies that prefer acquisition-led growth over organic growth, so when a company voices the desire for this flexibility to be able to make acquisitions more easily, it can be a warning sign."

Those who get AIM investment right can do spectacularly well. Marlborough Special Situations, which invests heavily in AIM, is the 15th best-performing among all unit trusts over the past decade, with a return of almost 300%, beating many of the racy emerging markets and commodities funds.

Manager Giles Hargreaves says: "There are lots of good companies on AIM. But, being smaller companies, if you get it right you will get much more appreciation than you would with a larger company."

They also tend to be under-researched - indeed, many companies on AIM have no independent analysts following them - and are largely ignored by the City pages. Spotting a company with potential requires intensive due diligence and research but those who find it may be able to exploit the potential on their own for a time before the attractions are more widely noticed.

"As long as you have your eyes open and are prepared to put the work in, there is a good reason to invest in funds that specialise in AIM," says Hargreaves. He has a team of around a dozen managers and researchers analysing shares, helping to uncover interesting opportunities.

But he has recently taken some profit because of the strength of the market. "A lot of companies have reached levels that we think are fully valued." That is particularly so among resources shares because, he says, "once the cycle turns, the chance to take profits is limited. You really do need to sell when they are going up: you could miss 10%, but you could also avoid being locked in as the price falls".

That need to be nimble and to research the market carefully means that, for most investors, buying through a fund is the most sensible way in. Indeed, AIM shares are specifically excluded from ISAs unless they are also quoted on another recognised exchange, which few are, so buying through a fund is the only way to get these tax benefits.

Mark Dampier at Hargreaves Lansdown likes the Marlborough funds, Nimmo's Standard Life funds and Investec UK Smaller Companies.

Alternative rewards: Tax breaks

For private investors, tax is one of the biggest reasons for investing in AIM. One of the most common schemes is to avoid inheritance tax through the use of business property relief.

These schemes involve buying shares in qualifying AIM-listed companies, which provided they are held for at least two years, will be exempt from inheritance tax when the owner dies. Given that inheritance tax is charged at 40% on assets over £325,000, that is a significant exemption.

Close Asset Management has been offering a service based on business property relief for a decade and now has £65 million invested in the schemes. Deryck Noble-Nesbitt, who runs them, points out that the risks are high. "It depends on the timing of when you put your money in," he says.

The worst-case scenario is an investor dying before the qualifying two-year period before the relief has kicked in, and where their shares have also fallen in value. But Noble-Nesbitt says that, if managed properly, the relief can be extremely valuable.

Patrick Connolly at AWD Chase de Vere says: "Any actions here need to be carefully thought through as the risks involved may outweigh any potential tax benefits."

He thinks the same holds true for the other key tax-planning vehicle involving AIM: venture capital trusts (VCTs).

These give 30% tax relief if the investment is held for five years but, he says: "Some highly respected investment companies launched AIM VCTs when VCTs were offering 40% initial income tax relief and investments only had to be held for three years. At that time investors jumped into these funds and many have since regretted doing so.

"Over the past five years, Invesco Perpetual AIM VCT has made a loss of 54%, Framlington AIM VCT a loss of 46% and the Artemis AIM VCT a loss of 19%. However, the Unicorn AIM VCT has made a staggering gain of 72%. These performance figures demonstrate the potential volatility of returns in this high-risk area."

Anyone wanting to get out of the poor VCTs will suffer even greater losses as their shares trade at big discounts - 27% for Framlington, for example - even assuming a buyer could be found.

As such, Connolly warns that it is essential that investors fully understand the risks involved before taking any action.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.

This article was taken from Money Observer, Moneywise's sister publication in April 2011