Investors can benefit from re-ratings game

This statement could, of course, be written about society at large. But equally it can be applied to the AIM market where the strongest, most reliable companies attract far higher ratings than both their peers on the main market and also their smaller, less developed counterparts on AIM.

Examples of AIM darlings can be found right here on our doorstep. Leeds-based Tracsis, a leading provider of technology to the transport sector, is one such company investors cannot get enough of. As a result, its shares trade on a forward price:earnings ratio (PER), a standard method of valuing shares, of 21x.

Contrast that with another technology business, Redditch-based Solid State, which supplies the rail and defence industries, among others, where the shares trade on a PER of just 12x. The difference? Both have a track record of delivering above-average earnings per share growth (Tracsis an average of 18 per cent per annum over five years and Solid State 15 per cent) but Tracsis has a market capitalisation of £140m whereas Solid State’s market cap is less than a third of that.

One of the drivers of such large disparities in valuations is the company’s size. Usually for reasons of liquidity, portfolio managers will prefer to invest in larger companies as they are easier to trade in and out of. And, following the usual laws of supply and demand, the more people that want to buy an asset, the higher the price.

On AIM, this disparity is particularly pronounced due to IHT-driven investment managers who will have strict checklists of what makes a company suitable for these tax mitigation portfolios.

Whilst profit growth, cash generation and dividends are all important, market capitalisation is often the single biggest determinant of what makes an AIM share “investable” or not. One major investor in AIM in our region won’t even take a meeting with a company unless its market capitalisation is capable of passing the £100m mark. This leads to a two-speed market of AIM’s haves and have-nots.

The canny reader may have spotted an opportunity here: by identifying those companies capable of getting onto an IHT portfolio buy lists before they do, there can be a substantial re-rating opportunity.

Is it better to buy a £50m market cap company on a rating of 10x or a £100m market cap company trading on 20x? The market can be highly inefficient within the £50m-£100m market cap range and, dispensing with the start-of-year tradition of giving share tips, below we identify how investors can potentially benefit from playing the great AIM re-rating game, an alternative investment strategy for 2017.

To take advantage of a re-rating opportunity on AIM, the key is to identify companies capable of getting on IHT portfolio Buy lists before they do. Portfolio managers will assess companies on a number of different criteria before deciding to invest. Here are some worth following:

1) Invest in companies capable of becoming £100m market cap companies. This probably means looking in the £50m-£75m range now before they get onto the radar.

2) Ignore companies that don’t pay a dividend. IHT-driven investors look for yield and the ability to distribute excess cash is seen as an endorsement of the strength of the balance sheet.

3) Look for above-average long term growth. This doesn’t need to be stratospheric but anything into double digits at the earnings per share level is worth considering. Check this over a period of, say, five years rather than just one or two to smooth out the performance.

4) Always ensure cash generation follows profits. Cash is king.

5) Avoid highly cyclical sectors. Make sure recent performance is more than a function of a cyclical recovery – some sectors come in and out of favour making them inherently unsuitable for an IHT-driven investor.