Investing in the junior market is risky, thanks to these obstacles.
The dream of all investors is to buy an asset which breaks the 'golden rule' by providing market-beating returns without added risk.
For instance, until 2008, hedge funds and other investors piled into US mortgage bonds and their derivatives. These securities paid a higher income than ultra-safe US Treasuries, but carried the same AAA rating. Thus, these investors thought that they were getting something for nothing: an extra reward with no extra risk. The carnage of the past two years shows how ruinously wrong they were!
Despite the best efforts of financial innovators, it seems that risk and reward are closely tied together -- as two sides of the same coin, if you like. Nevertheless, given that I have perhaps 25 years to retirement, I am happy to take on more risk in the expectation of higher reward. That's why I like to hunt at the small-cap end of the market, particularly in AIM-quoted shares.
However, fishing among the 1,400 or so company shares currently quoted on the Alternative Investment Market (AIM) is not without its risks. Despite the apparently mouth-watering bargains on offer, investors need to tread carefully and watch out for the following pitfalls:
1. Delisting
Here are five words to strike fear into the hearts of AIM investors: Notice of Intention to Delist. In order to delist, a company requires the approval of three-quarters (75%) of its shareholders. Alas, even with the hurdle set as high as 75%, minority shareholders are often left in the lurch by delistings.
In the 12 months to 31 March 2009, a total of 290 companies delisted from AIM -- an increase of a third (33%) on the 218 delistings in the year to March 2008. Although 95 of these 290 companies delisted due to mergers and acquisitions, 70 stepped down because they had no nominated adviser (Nomad), and 40 quit because of the burden and expense of maintaining an AIM listing.
One delisting which was keenly followed on the Fool discussion boards was the attempt by facilities-management group GSH (LSE: GSH) and its 83.9% majority shareholder Ian Scarr-Hall to take the company private.
Initially, GSH intended to delist without buying out its minority investors. However, following a campaign by Fool poster Carmensfella, GSH offered 190p a share to buy out minority shareholders. GSH's shares were delisted on 10 August, but there is still no guarantee that shareholders will get any tender offer to buy out their remaining stakes. Ouch.
2. Director holdings
Following on from the above, the issue of large director holdings should always be at the forefront of AIM investors' minds. Ian Scarr-Hall was able to impose his will on GSH's minority owners simply because he owned over five-sixths of GSH's issued share capital. In many respects, GSH's other stakeholders were investing in what amounted to a family firm which maintained an AIM listing purely for kudos.
This situation exists in many AIM companies, where small market capitalisations, put together with large family or director holdings, leads to problems. Thus, investors in AIM companies (and small companies in general) should always be aware of the potential for a conflict of interest between themselves and the directors or majority shareholders. When push comes to shove, minority shareholders always seem to come off worse!
3. Liquidity
Another problem with small-cap shares is their lack of liquidity, which is in part due to point two above. AIM shares in particular are noted for their illiquidity, which means that they are difficult to trade in large volumes. Indeed, for some AIM companies, it is normal for no trades to take place on any given day. Often, this illiquidity is worsened by large holdings controlled by directors, founders or families.
Take, for example, the near-fivefold increase in the share price of eXpansys (LSE: XPS) last month. Dragon's Den entrepreneur Peter Jones revealed in a Telegraph interview that he owned over four-fifths of AIM-listed eXpansys, sending its shares soaring through the roof. Given that fewer than 9% of eXpansys shares were available for trading, private-investor buying created a liquidity squeeze and an inevitable share-price surge.
Hence, when investing in AIM companies and other small-caps, you must factor in the liquidity of your investment. First, check the spread: the difference between the quoted buying and selling prices. For AIM shares and other small caps, this can exceed a fifth (20%) of your investment.
In addition, study the daily trading volumes and find out the NMS (Normal Market Size) of a company's shares -- the maximum number of shares for which a dealer or market-maker is obliged to quote a price. Otherwise, you could find yourself trapped in an illiquid share as its price plunges, which has happened to me on more than one occasion in recent years!
4. ISAs
Another drawback to AIM shares is that they cannot be held inside an ISA (Individual Savings Account). The advantage of investing in shares inside an ISA is that you pay no capital gains tax (CGT), plus there is no extra tax to pay on dividends received.
So, although the maximum yearly limit for ISA contributions is set to increase to £10,200 per tax year from 6 April 2010 (6 October 2009 for the over-50s), AIM investors can't enjoy this extra tax break. In fact, the tax position for AIM shares has actually worsened in the past 18 months.
Until 5 April 2008, keeping an AIM holding for two years would reduce your CGT rate from up to 40% to the 10% rate applied to 'business assets'. Since 6 April 2008, AIM gains are taxed at a flat 18%, which means that they no longer enjoy a CGT advantage over shares listed on the main market. (There is, however, an Inheritance Tax break on AIM shares.)
In summary, there are lots of excuses to avoid AIM shares, such as their dominant management, illiquidity, high spreads, tax inefficiency and so on. Nevertheless, even after taking these snags into account, there are some terrific bargains available in the AIM shop, so I'd encourage you to take a look...
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