For investors and economists, it is both logical and useful to group together the largest companies in a stock market. The FTSE 100, for example, is a largely reliable collection of assets, because its constituents tend to have a strong track record, which in turn leads to benefits of size and scale. In short, its constituents are generally more predictable in terms of their performance - and investors put a premium on predictability.
At the other end of the market capitalisation league table, there is more scepticism around grouping smaller companies, despite their numerous virtues and potential benefits to investors. But while small companies can be more nimble than their larger FTSE 350 siblings - and capable of generating outsize returns for investors - there are huge variations in performance and quality. Small caps are usually a riskier bet, often misunderstood or under-researched and in many cases subject to liquidity issues.
FTSE Flegling vs small-cap vs Aim
Last year was not a glowing advertisement for investing at the junior end of the market. When taken as a group, the smallest companies listed on the London Stock Exchange had a poor 2014, by almost any measure. The FTSE Small Cap index - which comprises just under 300 companies that sit below the FTSE 350 - dropped 1.5 per cent in the year, against 0.7 and 1.2 per cent rises in the FTSE 100 and All-Share indices respectively. The Numis Small Company Index (NSCI), which represents the smallest tenth of the fully listed UK equity market, and has outperformed the FTSE All-Share since 2005 with a compound annual growth rate (CAGR) of 10 per cent, trailed the larger benchmark by 40 basis points.
Aim's annus horriblis
Collectively, Aim constituents had a particularly weak 2014, both in absolute and relative terms, with the Aim All-Share falling 16.5 per cent in the calendar year, according to Numis. Just 32 per cent of the companies trading on Aim for the duration of 2014 saw a share price increase during the year, with the remaining 525 companies moving lower. A sector analysis of the index makes for equally bleak reading. Eight areas posted double-digit losses, with the oil and gas and automobile indices falling 47 per cent and 48 per cent respectively. The FTSE Aim All-Share Technology index, often viewed as one of the most exciting portions of the junior market, fell by a quarter, while the telecommunications and retail indices both lost more than a third of their market value. The basic resources index, exposed to the vast number of mining start-ups on Aim, also saw its value fall by more than a third. Just five Aim sectors saw meaningful growth in the year: real estate (39 per cent), healthcare (16 per cent), chemicals (12 per cent), financial services (8 per cent) and travel and leisure (6 per cent).
There were some big individual losers, including the well-documented 86 per cent drop in legal services provider Quindell's (QPP) share price after queries were raised over its accounting practices. Contract issues and missed revenue targets all but wiped out the entire market value of mobile commerce group MoPowered (MPOW), while revenue-recognition issues at blur (BLUR) also knocked 89 per cent off the price of the previously hot stock.
Pockets of hope
And yet there were certainly pockets of hope, (or perhaps puzzlement, for an investor trying to identify anything resembling a pattern). Excluding investment companies, the FTSE Fledgling Index - made up of the companies too small to make it into the All-Share - returned a very strong 12.7 per cent in 2014.
Nonetheless, there are discernible patterns for investors looking to back a spread of smaller companies. Numis and London Business School professors Elroy Dimson and Paul Marsh have found that within the small companies universe - or at least among the fully-listed companies in the NSCI - the most successful investment strategy in the last decade has been momentum investing, which involves buying or retaining stocks which have performed well, and selling companies which have lost value. In 2014, backing proven winners produced a 9.1 per cent premium, or more than 20 per cent on an annualised rate over the last decade.
With this in mind, it is worth noting a few of the smaller companies that had a strong 2014. Although technology lagged as a sector on Aim in 2014, it was an important year for Solid State (SOLI) and Ilika (IKA), both of which manufacture solid-state batteries - the next generation of energy efficient, lightweight wireless power - and were two of the highest risers on the junior market over the course of the year, up by 182 per cent and 336 per cent, respectively. Butchers Crawshaw (CRAW) may operate in a less exciting sector, but it was one of the most exciting stocks on Aim in 2014, rising 197 per cent on the back of a well-received acquisition, chief executive appointment, and reliable dividends.
A mixed bag of new issues
When it comes to the performance of new entrants to Aim, the post-IPO share price performance by the year-end provides a mixed picture. Payment solutions group SafeCharge International (SCH) saw a 56 per cent leap in its valuation between the close of its first day of trading and 31 December, while Patisserie (CAKE) - parent company of the Patisserie Valerie chain - made a gain of 37 per cent. Despite a troubled year for the broader retail sector, Shoe Zone (SHOE) had a strong debut, adding 25 per cent to its share price between its May admission and the year-end. Other entrants dropped significantly after flotation, including boohoo.com (BOO) - which fell 44 per cent, and tailoring group Bagir (BAGR), which saw an 82 per cent fall in its share price.
Such variation supports Dimson and Marsh's analysis that Aim is a confounding market for investors. It raised some £2.4bn for small companies last year, contributing to a market value of £71bn by the end of 2014. But despite a strong history connecting companies with investor capital, a good chunk of that value has been destroyed. An investment tracking the Aim All-Share index since its inception in 1996 would have lost investors 25 per cent. By comparison, with an annual return of 8.9 per cent, the NSCI would have netted investors a 353 per cent return over the same period.
The picture is all the more difficult to fathom when you consider the relative outperformance of smaller companies globally, which has been replicated in almost every major market in the world since 2000. But the gradual erosion of the Aim index's values through 2014 is largely a pointer to sector-specific risk. With a heavy weighting towards resource stocks, the performance of the Aim All-Share index was undermined by the fall-away in global commodity prices in the second half of the year. Geographic factors obviously need to be taken in consideration, too. Markets were certainly buoyant for smaller stocks across the pond. Last year, the Russell MicroCap index, which follows smaller US listed companies, outperformed its larger counterparts - the Russell Top 200 and Russell 2000 - chalking up 13 per cent returns. That represents a far superior performance to the Aim All-Share, even when you strip out the poor-performing resource sectors.
IC VIEW:
There is little reason to doubt the ability of small companies to produce strong, sustained investment returns. But 2014 was a good reminder of a key lesson when it comes to Aim and smaller companies in general: individual stock-picking, while riskier, is the only strategy to help to flush out very large numbers of underperformers. While momentum strategies can help, this same herd mentality can end up pushing up the price of unproven small company stocks to high forward-earnings ratios. Investors with the patience and the will to find small companies with strong fundamentals will unearth the gems. But as a home for your hard-earned capital, Aim continues to look less attractive than the main market.
