Super small caps

Naturally, most companies aren’t going to become Apple-type success stories. But a tiny number will and we’ve put together a portfolio of companies that we think have the potential, at least, to make it big. First, however, a health warning: these companies aren’t for widows and orphans. The risks are huge. While their unique characteristics may well lay the foundations for huge success stories, they usually have little in the way of a ‘plan B’.

Spotting winners

So what characteristics should a company have to make it as big as an Apple or a Google? The answer, of course, will differ according to the sector. In technology or pharmaceuticals such companies will be touting an innovative idea with plenty of potential – so intellectual property really matters. Such companies may be generating no profits, or sales, and they may be burning through investors’ cash at an appalling rate. In such circumstances, an excellent grasp of the market that their product is focused on is crucial – as well as something of a leap of faith.

For others, such as oil and gas explorers or miners, it’s all about the value of what they can literally dig out of the ground. Such companies may own prospects where the geological data points to a good chance of big transformational find. They too may be burning through cash digging wells or mines – so, as with those that are dependent on the quality of their intellectual property – conventional metrics such as sales and earnings just aren’t that important. Again, faith is needed that these companies’ efforts will reveal the hidden riches that their research points to and that these valuable resources can actually be extracted economically.

Then there are those companies that are looking to exploit change in an existing market niche with an innovative approach. True, a good number of such companies will be technology-focused plays. But in a world where the big banks are still reeling from the implications of the financial crisis there are plenty of innovative new financial companies emerging that fit this description. Such companies are generally experiencing a rapid growth phase and are usually grabbing market share from more traditional players. Unlike tech-wannabes or strike-it-lucky resource companies, some may already be generating earnings and paying dividends, too.

With that in mind, we’ve identified 10 companies where the upside from success could be huge but, in most cases, where failure could leave investors nursing heavy losses.

1. Intelligent Energy (IEH)

The world’s worryingly high dependence on finite fossil fuels for its growing energy needs is a problem that needs no elaboration. So companies that can offer an energy future that’s free of such fossil fuel dependency inevitably attract attention. One such promising prospect is Intelligent Energy (IEH), which makes hydrogen fuel cells. These produce power by combining hydrogen with oxygen and – while the basic technology itself has been around for many years – recent advances have led to such cells becoming much cheaper and more accessible for a range of different uses.

Admittedly, a great deal of hope has already been factored into the share price. The company – which was started by Loughborough University academics – floated on the main market in July and now boasts a market value of over £400m. That’s a lot for a company that generated just £21m of sales in 2013 and which made a £29.8m pre-tax loss. But such hope is, at least, easy to understand. For example, the company’s consumer arm has developed a fuel-cell mobile phone battery charger and, at around the time of the IPO, it was reported that the company was working with Apple to embed that technology into such devices as smartphones and tablets. Given demand for these products – in 2013’s fourth quarter, for example, Apple sold nearly 34m iPhones – it’s easy to see how sales at Intelligent Energy could rocket. The company also makes fuel-cell powered generators for India’s mobile phone towers. And its work on fuel-cell engines for automotive use has delivered partnership deals with big players such as Suzuki.

Brokers haven’t produced any research yet – that’s due later this autumn – so quantifying growth isn’t easy. Intelligent Energy isn’t the only fuel-cell player, either. But it is the UK’s biggest – Ceres Power (CWR) comes next with a market value of £80m – and its product range is possibly the most promising. With fuel cells virtually guaranteed to play a big role in the word’s energy future – the hydrogen energy market is forecast to be worth over $180bn (£109bn) by 2015 – then Intelligent Energy looks like the horse to back.

2. Rose Petroleum (ROSE)

At the start of the year, Rose Petroleum’s (ROSE) market value was a mere £5m. By May, however, that had soared to almost £50m and it’s conceivable that there could be plenty more upside to come.

That’s because, in March, the Aim-traded oil explorer bought a 75 per cent interest in 230,000 acres of land in Utah (above) in the hope of making a killing from extracting shale oil and gas. It paid a mere $0.5m for that and agreed to pay a further $1.5m in instalments on the understanding that it will carry its partner on drilling costs.

Just two months later an independent report compiled by Ryder Scott – among the most widely-used independent consultants in the US sector – suggested that the site could contain around 1.5bn barrels of recoverable oil (within the Mancos shales) along with 4.8 trillion cubic feet of gas (within the Paradox clastics). That’s more than three years of North Sea oil production and is equivalent to 18 months-worth of UK gas consumption. This news was followed by a second report from independent consultant Christie Ward Schultz who calculated a combined total net present value of the find of over $2.4bn – nearly 35 times Rose’s current market value.

But there are huge risks. After all, the group’s land remains largely untested: this autumn a horizontal well will be drilled at the Mancos and an old existing closed well will be tested in the Paradox. Earlier this month the group reported that good progress with this was being made. But there are enough successful wells nearby for analyst Harry Stevenson of broker Beaufort to say the risk has shifted from “is the oil there” to “can the oil be produced commercially”. If it can, the share price upside to come could dwarf the price rise already seen earlier this year. If it can’t, a market value that’s nearer the level seen at the start of the year could easily beckon.

3. Wentworth Resources (WRL)

Not quite in the same category of downside risk as Rose – but with plenty of upside potential nonetheless – is oil and gas play Wentworth Resources (WRL). It’s focused on potentially risky onshore programmes in Mozambique: the Tembo and Kifaru projects.

Working with partner Anadarko Petroleum, it’s hoped that Tembo alone could contain 255m barrels of oil-equivalent. Analysts at broker Investec Securities estimate that could be worth as much as 58p a share, although the exploration well that’s being drilled there has suffered equipment-related delays. Adding in the value ascribed by Investec to Kifaru and the broker reckons the two projects combined could be worth 80p a share – almost twice as much as the company’s current 45p share price. However, with the broker also attributing 15 per cent and 14 per cent chances of success at Tembo and Kifaru, respectively, then it’s clearly a risky punt.

Still, if the two projects do fail to deliver, then – unlike with the likes of Rose – all is not lost. That’s because it also has a gas project in Tanzania that’s due to come online once the Dar es Salaam cross-country pipeline – currently being built by the Chinese – is completed (by the first quarter of 2015). Moreover, earlier this month the group wrapped up negotiations with the Tanzanian government for a gas sales agreement.

4. Nanoco (NANO)

Moving onto the tech-related sector and Manchester-based Nanoco (NANO) stands out. It makes so-called quantum dots, which are tiny particles of semi-conductor material with potentially huge implications for LCD TV displays, LED lighting and solar energy. Indeed, Nanoco’s cadmium-free quantum dots offer better brightness, colour and power-efficiency than current similar LED-type technology.

Nanoco’s problem, however, is production. It currently can only produce around 40kg-50kg of dots a year – not nearly enough to supply the millions of TVs and other displays that are produced each year. So the group licensed the technology to Dow Chemical last year. Dow can scale-up Nanoco’s production to 800kg a year by building a new South Korean facility which will also bolster the offering’s credibility with such regional manufacturers as Samsung and LG. But the new factory isn’t built yet and there remains a worrying absence of commercial contracts. It didn’t go unnoticed within the industry, for example, that Samsung failed to show a quantum dot-based TV at the last Consumer Electronics Show in Las Vegas.

Despite that, however, analysts are increasingly of the view that a first contract may be close at hand. Liberum notes “the increasing number of articles in the Asian press, particularly in Korea, on the potential use of quantum dots by Samsung and LG”. The broker continues to “expect a contract to be signed shortly” and for sales to soar from just £1.4m in 2014 to nearly £51m by 2017 – giving earnings of 17.1p a share in that year. Applying a multiple of 15 times to that estimate, leads the broker to a 260p share price target, compared with 117p now. If a contract continues to remain illusive, however, sentiment could slip sharply – the shares have fallen over 30 per cent since last September.

5. Blur (BLUR)

Blur (BLUR) operates an online exchange that allows businesses to commission services from providers and – given the growth profile – it has the potential to become something like the eBay of the services world.

Growth has certainly been impressive. In 2013 Blur reported that the average brief value had soared by nearly 200 per cent while the number of briefs had risen 169 per cent. Business is streaming in from large blue-chip companies, too, and Blur is expanding overseas through an affiliate and partnership structure. It now boasts a referral partner network of over 1,000 organisations worldwide. Analysts therefore expect rapid growth. Broker Liberum, for example, forecasts sales to grow from a mere $2.8m in 2012 to over $57m in 2016.

The risks to this growth story, however, basically reflect Blur’s ability to cope with the pace. The company is investing heavily in systems and controls: administrative expenses almost tripled in 2013 and, at the half-year stage, more than doubled. It therefore tapped shareholders in June for a further £13m of funds through a placing and open offer. Moreover, Blur has run into trouble with its auditors – essentially, they required management to adopt a more conservative policy regarding revenue recognition. Such issues have seen the shares tumble from 793p in January to just 82p now. Even modest profitability isn’t expected until 2016, and investors can forget about dividends for years to come.

There’s plenty of evidence that Blur’s offering is quickly being adopted as the service commissioning platform of choice – not just by small businesses but by blue-chip players, too. If Blur is up to the challenge of fully utilising that opportunity – and the market doesn’t appear to be entirely convinced that it is – then expect the shares to re-rate strongly from their presently depressed levels.

6. Fusionex International (FXI)

Computers, mobile devices and social media are constantly churning out huge quantities of data on their users – known as ‘big data’. That contains potentially lucrative information for organisation such as advertisers and retailers on customer preferences, but accessing it isn’t easy. That’s where Fusionex International (FXI) sees its chance to hit the big time.

The company provides software to make use of that data and, crucially, its offering is emerging as the most user-friendly package on the market. In December it launched GIANT – Fusionex’s flagship big-data product that offers a point-and-click interface compatible with a great many devices and servers – and the tech industry is impressed. In fact, Fusionex has won the innovation award at the Microsoft Worldwide Partner Conference for three years running and IT industry experts continue to praise the virtues of GIANT’s easy-to-use nature. Take-up of the product is therefore proceeding at quite a pace. GIANT contributed about £2.6m to Fusionex’s sales growth in the first half and the company has already secured six clients spanning the aviation, hospitality and retail industries. Fusionex has also recruited two of the best-known big-data platform distributors, Cloudera and Hortonworks, to its network. It has partnered with IT-distribution giant Avnet, too, which will push its product in over 80 countries.

Of course, it’s early days in the big-data analysis arena and it’s possible that Fusinonex’s product will be trumped by a better offering at some point. But, for now, the company looks like the best play on big data in the sector. Growth is therefore expected to be rapid and broker Panmure Gordon expects sales to almost double in the three years to the end of September 2016. Unlike many in the tech sector, Fusionex already makes profits, and there’s a modest dividend. Yet Panmure points out that shares are rated on a price-to-earnings growth (PEG) ratio of around 0.7 times – PEG ratios of below one are usually considered cheap.

7. ReNeuron (RENE)

ReNeuron (RENE), like plenty of small biotech companies, hopes that its research has the potential to deliver a blockbuster product of transformational proportions. Unlike most of those other biotech wannabees, however, ReNeuron may just have what it takes to make it big.

That’s because it’s focused on researching stem-cell products and, unlike conventional drugs – which typically address symptoms – stem-cell therapies can potentially tackle the underlying causes of a disease by stimulating natural repair mechanisms. ReNeuron’s efforts include the development of a product for critical limb ischaemia (a severe blockage in the arteries of the lower extremities) – ReN009 – as well as an anti-blindness treatment (ReN003). But the group’s star product (ReN001) is undoubtedly its stem-cell therapy for treating patients left disabled by the effects of a stroke. Given that around half of the millions of people each year that survive a stroke are left disabled, the potential from such a product needs little elaboration. And existing treatments are focused on preventing strokes, so the product would be unique.

Of course, there’s always the risk that ReNeuron could fail in clinical trials at some point – it wouldn’t be the first time in the sector’s history that an apparently promising product eventually came to nothing. Moreover, progress will be slow. While Phase I trials delivered positive results for the company’s stroke treatment, Phase II trials only opened for patient recruitment in May. Analysts at broker Edison aren’t forecasting any sales for the foreseeable future and steady post-tax losses of around £6m-£7m a year are anticipated as ReNeuron burns through its cash pile (£14.9m at end-March). Still, the potential from ReNeuron’s stroke product is undoubtedly huge and, should Phase II trials prove successful – the results are expected by end-2015 – the shares could soar.

8. Tungsten Corporation (TUNG)

Tungsten Corporation (TUNG) is relative newcomer – it floated on Aim last October – but it boats impressive potential. It used the proceeds raised to snap up e-invoicing platform OB10 and, as companies and governments increasingly embrace e-invoicing as their preferred means to pay suppliers, growth could be stellar. Indeed, Tungsten’s transaction flow volumes have nearly doubled to over £100bn since 2011, yet it’s estimated that a mere 3 per cent of invoices are currently settled electronically.

Tungsten also boasts robust growth opportunities from invoice financing – lending money to small businesses against unpaid invoices. The company now has its own bank to help fund this after having bought the UK arm of the First International Bank of Israel earlier this year. It’s also working with Blackstone Tactical Opportunities to establish a special purpose financing vehicle with an annual funding capacity of $10bn-$12bn.

But there’s plenty of risk. It’s still early days for e-invoicing and serious competition could yet emerge. Moreover, the company’s customer base looks ‘lumpy’. In its IPO document, for example, Tungsten notes that 22 customers account for three-quarters of the total transaction value processed. So losing just some of those customers could “have a material adverse effect”, notes management.

Tungsten is also still effectively in start-up mode, so costs are rising fast, and an annual meeting statement this month emphasised that 2014-15 will be a year of investment. The company is therefore loss-making and dividends aren’t likely for years. But if Tungsten can keep up the pace then its potential is hard to ignore. Analysts at broker Canaccord Genuity expect profitability to be achieved in the year to end-April 2016 – EPS of 21.9p is anticipated in that period – and for earnings to almost double in the two years to end-April 2018. Such prospects have helped propel the shares up by over 80 per cent since May.

9. Plus500 (PLUS)

Also relatively new to Aim is Israeli group Plus500 (PLUS) – it floated in July 2013. It offers an online contracts for difference (CFD) retail trading platform and, at a time when rivals such as IG Group (IGG) have seen lower trading volumes amid low levels of market volatility, Plus500 has been growing fast.

CFD trading allows investors to speculate on market price movements without the expense of owning the underlying asset. That’s boosting the popularity of this form of trading and, unlike with some rivals, customers are also being attracted by the group’s commission-free pricing structure. Instead, Plus500 makes most of its money by taking a slice of the spread between the bidding price of an underlying asset and the asking price. It’s a model that saw the group’s new customer numbers soar by a third in the first-half compared with the same period last year, while half-year revenues jumped 137 per cent year on year.

Yet Plus500’s cost structure is well below its rivals: broker Liberum estimates that its annualised revenue per employee stands at about $2m compared with around $0.6m at IG Group. Accordingly, earnings growth is rapid and the group is able to support a fat dividend. Numis Securities expects earnings to rise from 2013’s 47¢ a share to 91¢ in 2014, before jumping to 101¢ in 2015. The broker expects a 54¢ dividend for 2014, too, meaning a prospective yield of over 8 per cent.

But Plus 500 is not a risk-free punt, though. Revenue could yet suffer if low-volatility conditions persist, and the rate of new customer acquisition slowed dramatically in the second quarter – it attracted just 279 more new customers than in 2013’s second quarter. The shares have taken rather more than just a breather in recent months, too, after having fallen around over 40 per cent since mid-April.

10. OneSavings Bank (OSB)

At a time when policymakers are focused on a perceived lack of competition within the UK’s banking sector, much hope is being placed on the emergence of the so-called challenger banks. Such players include the likes of Metro Bank – which has yet to list but is busy grabbing market share from the high street banks organically after opening 27 branches. Another example is TSB (TSB), which was spun out of Lloyds in June as the price demanded by EU competition regulators for state support during the financial crisis.

TSB, of course, was born with a certain scale – unlike OneSavings Bank (OSB), which was formed from the acquisition of the Kent Reliance Building Society’s mortgage assets in 2013 and which only floated in June. But it has been growing fast and – given that it doesn’t compete quite as directly with the high street lenders as the likes of Metro Bank – it’s our preferred bet to emerge as the best-placed of the recent crop of new lenders. After the Kent Reliance move, for example, it bulked up its scale further with last year’s acquisition of Northern Rock’s consumer finance book.

That also came with a higher-margin book of business than the bank’s existing book of residential mortgages. Since then, the lender has made good progress with rapid organic growth. Lending at its buy-to-let and small and medium-sized business unit, for example, soared 160 per cent at the half-year stage and the residential mortgage book grew its organically originated loans by a quarter.

Of course, the high street banks will become less choosy about lending as the economy continues to recover, so all banks in OneSaving’s position can expect competition to grow. Regulators can be immensely cautious about allowing new banks to progress quickly as well – they often require management teams to demonstrate lengthy track records before allowing them to chase growth. The expensive nature of bank regulation – reflecting such factors as hefty capital requirements – also makes life tough for small new banks. But with a recovering economy to drive credit demand, and with the big banks still tackling a host of legacy issues from the financial crisis, there has rarely been a better time for a player such as OneSavings to hit the big time. That said, the shares are no bargain – they trade on over twice forecast net tangible assets.

How the mighty fall

Before jumping in to try and spot tomorrow’s winners, it’s worth taking a look at some notable failures, and few cases better demonstrate the risks to this particular game than Pursuit Dynamics.

As recently as 2012, it was wowing investors with the potential from its radical liquid processing technology which could, apparently, deliver huge savings for customers.

High hopes for the technology helped the shares soar to over 700p by late 2010 and the company’s broker, Mirabaud Securities, even set a price target at 2,100p. But its problems began in May 2012 when a potentially transformational tie-up with Proctor & Gamble fell through. That left revenue expectations looking hopelessly overdone and the shares collapsed so far that they permanently joined the ranks of the penny shares. The company has since abandoned its technology altogether, and in July it completed the reverse takeover of three social gaming and gambling businesses – leading to the cancellation of its Aim listing.

The rise and fall of Pursuit Dynamics

It’s also instructive to look at the factors behind the decline of the formerly great – these often reflect a failure to see change coming and to adapt in time. US film rental group, Blockbuster, is a good example. Its first stores were opened in Dallas in 1985, and at its peak it employed 60,000 people with over 9,000 stores. It successfully expanded into around a dozen countries, too – including the UK where it became the top video rental store after the acquisition of the Ritz Video chain in 1992. But while the group easily adapted to the switch from video to DVD, it proved rather less able to innovate elsewhere. In fact, Blockbuster remained well behind the curve as the rise of DVD rental by mail and video streaming over the web stormed into its market – led by rivals such as Netflix and Redbox. Blockbuster’s revenues began to collapse, and by September 2010 the group had filed for bankruptcy. Ironically, in 2000 Blockbuster had the chance to buy Netflix for just $50m – but it declined to do so.

Another good example of a failure to adapt to web-driven change can be seen with business directory publisher Yell – which changed its name to Hibu in 2012. Famous for its Yellow Pages local business directories, the company expanded from the UK into Spain, the US and South America. The trouble was that its business advertisers lost interest in paying for a listing in a paper directory at a time when customers were increasingly turning to the web to search for services. Yell’s efforts to build an online presence proved too little, too late, and by 2012 the company reported a painful £1.4bn pre-tax loss. Its market value had slumped to less than £60m by that point, too – from £850m in 2010 – and Yell found itself labouring under an immense £2bn-plus debt pile. Last year Yell’s lenders took control of the company in a move to restructure it and it delisted from the London Stock Exchange in November.