Danger signs

In 1962, Mr Buffett was running a small hedge fund with assets under management of around $7m (£4.08m). He was buying shares in a struggling American textile company after noticing a pattern that its share price spiked up whenever the company closed a mill. “By 1964, we had quite a bit of stock. I went and visited the manager, Mr Stanton. And he looked at me and he said, ‘Mr Buffett, we’ve just sold some mills. We’ve got some excess money. We’re gonna have a tender offer. At what price will you tender your stock?’ And I said, ‘$11.50.’ And he said, ‘Do you promise me that you’ll tender it at $11.50?’ And I said, ‘Mr Stanton, you have my word that if you do it here in the near future, that I will sell my stock at $11.50.’”

A few weeks later, Mr Buffett received the tender offer from Berkshire Hathaway. The price was $11 and three-eighths. “He chiselled me for an eighth. If that letter had come through with $11 and a half, I would have tendered my stock. But this made me mad. So I went out and started buying the stock, and I bought control of the company, and fired Mr Stanton. Now, that sounds like a great little morality tale at this point. But the truth is I had committed a major amount of money to a terrible business.”

It took Mr Buffett 20 years before he gave up on the textile business. “I had a wonderful guy running it – we just couldn’t make it go. We weren’t done in by anything other than competitive dynamics. We would buy new equipment or we would add this mill in Manchester (New Hampshire) and we’d say look at all these synergies.” He later bought a good insurance company for Berkshire that would eventually become the base of his now $313bn investment vehicle. His parting piece of advice for investors: “If you get in a lousy business, get out of it. It’s much better to buy something that’s good at a fair price, than something that is cheap at a bargain price.”

The good, the bad and the Alternative Investment Market

With just shy of 1,100 companies traded on Aim, separating the wheat from the chaff is easier said than done. Moreover, for the past several years share prices of most small-cap stocks have been rising steadily – sometimes regardless of company fundamentals. Since the start of 2012, the FTSE Small-Cap Index has risen in value by nearly two-thirds and is now perched at an all-time high. Finding a fair price is difficult enough, let alone finding a bargain.

Don’t get us wrong: we remain big fans of small-cap stock-picking here at the IC and expect the broad stock market rally to continue for some time. But it’s important not to get carried away, and to remember that there are additional risks inherent in small-cap investing. (Note: we make no distinction in this article between nano caps, micro caps and small caps.) We advise running the rule over your current portfolio and asking the following questions before investing in any new company. Digging deeper into company accounts, meeting management whenever possible and understanding the business model will go a great deal toward avoiding stock market lemons – not to mention finding the real winners.

Management matters

Clearly, the success or failure of a small business is a result of many factors. But by far the greatest determinant is management. And the quality of management can vary widely.

At an early morning meeting with a tiny Aim-traded oil explorer a few months ago, the chief executive arrived dishevelled, bleary-eyed and extremely animated. Later the company’s external public relations rep quietly explained that the executive had been out partying heavily the night before with some market makers and the company’s house broker. It’s a simple example, but needless to say, shares in the company seemed like a much less attractive investment idea having seen who was actually running the business.

• Meet management whenever possible, attend a company’s general meeting, watch videos of interviews with executives, or attend a private investor seminar or conference where management are presenting. This can go a long way toward establishing whether management are up to the job or not.

• Always check management’s track record. Have they ever run a listed company before? If so, what happened to the share prices of those companies? Are they paying themselves an excessive salary? Check the company’s latest annual report where you’ll find salary and bonus information; beware ‘lifestyle companies’, where management have been in place on large retainers for many years but the business has not really progressed (see the Leisure Canada case study).

Key shareholders

All too often, investors focus on whether a big-name institution is a shareholder or whether directors have been buying or selling. While these are undoubtedly valuable things to research, there is a more pressing corporate governance issue that concerns retail investors.

• Who are the company’s major shareholders’ Does any single person or entity control the majority of the stock, leaving minority investors with little or no influence?

It’s worth figuring out whether a company is being run for the benefit of outside shareholders, or for the benefit of a small number of large shareholders who are also board directors. There have been several recent high-profile cases on the main board of the London Stock Exchange – such as Indonesian coal miner Bumi or Kazakhstan copper miner ENRC – where majority shareholders have all too easily mistreated minority investors. On Aim, it’s lower-profile but much more rife. In 2014 alone, for example, at least five Chinese-based, Aim-traded companies have gone private or announced plans to voluntarily delist their shares. That has left western investors holding shares that are essentially worthless.

Finances

An in-depth look at a company’s accounts can often tell you more about a business than an hour-long chat with its chief executive. It’s not fool proof by any means – accounting standards are surprisingly bendable – but the financial statements present a good snapshot of how the business is doing financially. The first document I look at is the income statement.

• Is the company profitable? What are its margins like? Are its general and administrative expenses unusually large as a proportion of sales?

But where I usually find red flags is in the balance sheet. Take a look at the most recent balance sheet of logistics provider Interbulk (INB), for example, shown on page 28. It’s terrible.

Interbulk's balance sheet

The first thing you notice is that the company has a significant amount of net debt: £66.6m to be precise. That’s over 90 per cent of shareholders’ equity, which is actually negative if you stripped out £110m of goodwill and intangible assets.

In Interbulk’s case, the company is actually modestly profitable at an operating level. But after interest payments on its large debts, the company becomes loss-making.

Another red flag here is working capital. Current liabilities of £67.5m greatly exceed current assets of £52.2m. Inventories haven’t climbed, either, so I suspect the situation is even worse than it initially appears, since working capital can be window-dressed to flatter the balance sheet on the reporting date.

One piece of good news is that liabilities under the company’s pension scheme appear to be under control. But it’s always best to check the more detailed annual report figures to make sure (I checked – it’s fine).

Cash generation

The third thing you should always sink your teeth into is the cash-flow statement. Is the business actually generating cash? Or is it burning through it? If it isn’t producing cash, how long can it survive without raising more capital?

Again, take a look at Interbulk’s latest cash-flow statement.

Interbulk's cash-flow statement

The company generated £5.9m from its operating activities, and the sale of property or equipment contributed another £0.3m. But it spent nearly £10.3m paying off the capital portion of its debt and the corresponding interest payments in the six-month period to 31 March. That means Interbulk effectively burned through £4.4m of cash during the period. Worryingly, the company only had £9m in cash left in its bank account at the half-year-end.

Earnings adjustments

The amount of cash a company has in its bank account is tricky to manipulate – but not impossible. Earnings are another matter; they’re far simpler to pump up.

The most common boosting technique for a small business is to include ‘adjusted earnings’ alongside or ahead of its reported figures. This can be perfectly acceptable in many situations. It simply highlights what trading would have looked like by stripping out the effects of a non-recurring event. The problem is that small-cap companies have to incur a lot of one-off expenses while growing.

Let’s look at Plastics Capital (PLA), a good-quality, niche manufacturer of plastic products and a successful former IC buy tip. In its most recent set of accounts, there was an enormous difference between Plastics’ adjusted and reported figures for earnings per share (EPS). In the year just ended they were 11.1p and 3.2p, respectively, with the difference made up of: amortisation of goodwill; acquisition and legal fees; redundancy and recruitment costs; bank refinancing costs; and “company set-up costs”. It is very questionable whether all these costs should really be considered ‘exceptional’, especially because the company has booked similar charges year after year.

Technology companies are often the worst culprits. One reason why is because it’s acceptable – at least by accounting standards – to capitalise some research and development costs as intangible assets. This is fine in theory: a company might pay its computer programmers to build a valuable piece of proprietary software, which it can put on its books as an intangible asset. It can then account for the cost later by writing down the value of the asset – or amortising it – over time. In practice, however, this scheme can be taken advantage of; companies can mask what would otherwise be recurring business costs by capitalising them under research and development, thereby falsely inflating the profit and loss figures. They can then also strip out the amortisation costs in their ‘adjusted earnings’ figures.

Understand the business model

Imagine you’re on the panel of the BBC’s hit show Dragons’ Den. What’s the first thing you want to know about a business: how is it going to make me money?

Does the company have an innovative new product? Or does it operate in a competitive market? Is the wider industry growing or contracting? Is its growth profile accurately reflected in the market valuation?

Aim is home to many hundreds of speculative companies that require constant funding to keep them alive while they ‘scale the business’, build a mine, acquire competitors, etc. Most of these, through natural selection, will slowly pass away and eventually delist.

• Watch out for ‘jam tomorrow’ companies that can be perennial disappointers

Revolutionary new products that promise to transform an industry are commonplace; what are rare are companies that can successfully commercialise them. It’s been 10 years, for example, since Ceres Power (CWR) first listed on Aim with the goal of bringing its household fuel-cell heating and power systems into commercial production. It remains locked in the development stage, however, despite signing agreements with many, many established partners along the way.

• Be wary of companies that grow very quickly by acquisition

Many companies primarily float on Aim to gain access to two currencies: sterling, from selling shares to investors; and common shares, with which they can make acquisitions. That’s all well and good, but often times companies turn acquisitive as a substitute for organic growth, not because of it. In our Silverdell case study, we look at how a ‘buy and build’ strategy can go woefully wrong.

• Beware companies whose success is dependent on external forces beyond management’s control

Changes in regulations can be a boon for some companies as a market is opened to competition. Take Software Radio Technology (SRT), the maker of tracking equipment for ships. It has also been listed on Aim for nearly 10 years now, all the while trying to shift its product in commercial quantities. And it periodically receives a huge influx of orders as one country’s government says all its ships must have a tracking device on them by a certain date. But all too soon it is quickly undone by another government delaying its mandatory installation date by another few years. The uncertain timing of orders has proved to be the company’s Achilles’ heel and has led to a string of profit warnings over the years, dampening the company’s share price.

We see this time and again with Aim companies. The investment case for Sirius Minerals (SXX), for example, hinges entirely on the company receiving approval from the National Park Authority in Yorkshire to build a large underground potash mine. See the case study on Leisure Canada for a further example.

Case study: Leisure Canada

Canadian penny stock promoter Walter Berukoff spent 14 years telling investors he would build a grand chain of tourist resorts in Cuba at the helm of aspiring real estate developer Leisure Canada. Speculative investors in Canada were led to believe they could capitalise on a potential Cuban tourist boom should Fidel Castro’s regime end, leading the US to lift its embargo and allow US citizens to legally travel there.

Yet Leisure Canada failed to ever complete even one set of hotel foundations on the island – despite Mr Berukoff helping the company raise more than $46m (£25m) between 1996 and 2010. He would have raised more – in 2009 he mooted a £50m float on the London Stock Exchange – but City investors fortunately kept their wits about them.

Mr Berukoff eventually left Leisure Canada to start gold explorer Lion One Metals (TSX-V: LIO), at the peak of the boom in gold mining equities. He raised nearly $25m from Canadian investors and quickly fell upon another tropical island destination to explore: Fiji. There, he acquired a large property boasting vast tracts of under-explored land as well as the ageing Vatukoula gold mine. He kept the exploration property for Lion One and sold the underperforming mine to Aim-traded River Diamonds, later renamed Vatukoula Gold Mines (VGM).

Following a string of operational issues and a collapse in the price of gold, Vatukoula’s share price plummeted from 200p a share to below 3p. A Chinese investment group now controls 74 per cent of the company’s shares; in May, they proposed to cancel the company’s listing on Aim.

As for the other two: Lion One is still exploring its Fijian property while paying Mr Berukoff an ample annual salary; and Leisure Canada is still dreaming about building its Cuban resort chain. However, new management wisely decided to diversify into other popular tourist regions and last month agreed to be bought out by the company’s largest shareholder.

Lessons learned: Try to meet management whenever possible – be wary of so-called ‘lifestyle’ companies, where management have been in place for many years on large salaries but have achieved very little.

Avoid investing in companies where the main business hinges on events beyond management’s control. Lastly, be wary of Canadian stock promoters! (Note: the author is Canadian.)

Case study: Silverdell

Bitterness, anger, disillusionment: these are just a few of the emotions shareholders in Silverdell were left with after the hazardous waste disposal group was forced into administration and sold piecemeal last year, leaving the common stock worthless.

Silverdell’s sudden collapse and delisting from Aim was as surprising as it was appalling; only weeks before the shares were suspended, management issued a reassuring trading statement about new contract wins. Moreover, retail shareholders were left in the dark for months as to what was going on and it’s still unclear what exactly went wrong.

Led by a relatively young chief executive with little prior experience of building a group by acquisition, Silverdell had snapped up several complicated businesses in quick succession. In the process, the group was transformed from a niche provider of asbestos removal services to a broader hazardous waste clean-up group focused on nuclear, power and chemical industrial site demolitions.

The new businesses required Silverdell to have a lot more working capital, as they involved higher upfront costs and slower repayment terms. But Silverdell failed to adequately strengthen the balance sheet with an injection of new capital, and instead relied on borrowing heavily from its bank, HSBC. When one of its divisions ran into trouble and received a winding-up order, HSBC lost confidence in the group and called in its loans, triggering the failure of the whole company. Silverdell’s shares quietly delisted six months after being suspended.

Lessons learned: Beware companies that grow very quickly via acquisitions. Not only are there more moving parts for management to preside over, but often management make acquisitions as a substitute for organic growth. In addition, make sure to always check there is a margin of safety within a company’s balance sheet. A company with net cash can usually survive a downturn in trading. But when a heavily indebted company runs into trouble, the debt providers – usually banks – are in control and equity holders are consequently reliant on the whims of bank managers.

Case study: Langbar International

The tale of Langbar International is still the largest and most outrageous fraud ever to have taken place on Aim. In retrospect, it was all too easy for a small group of middle-aged businessmen from continental Europe, Israel and Brazil to heap an estimated £100m-worth of losses on British investors – big City funds and retail shareholders alike.

The scheme was to create a bogus company, list it on the stock market, use false documents and rumour to inflate the share price, and then for company insiders to sell their shares at a huge profit. This classic pump-and-dump fraud came off largely without a hitch, too; that is, until two quick phone calls ended it all in 2005.

It all started when Crown Corporation debuted on London’s lightly regulated Alternative Investment Market in 2003. It claimed to have hundreds of millions in cash sitting in a Brazilian bank account supplied by a private company called Lambert Financial, said to be backed by wealthy families in Latin America and Israel. The plan was for Crown to invest the money in property and businesses in Argentina and Europe, among other things.

Many investors were rightly dubious, especially after the company released a series of outlandish official stock exchange announcements saying Crown had won gigantic construction contracts and rights to a major gold mine, as well as making major investments in Russian gas groups. It was not until a Yorkshire accountant named Stuart Pearson vetted the company and agreed to become its chief executive that demand for Crown Corporation’s shares soared (Mr Pearson changed the company’s name to Langbar, the name of his private consultancy company, which in turn was named after the village north of Bradford). Langbar’s share price rocketed from an original 10p to a peak of £10 as investors piled in.

According to The Guardian’s Simon Bowers, most City folk believe Mr Pearson was little more than a patsy – albeit one who had acted recklessly – and that he was also deceived. When Mr Pearson flew to Brazil to check the funds were genuinely there, he was told a bomb scare at Banco do Brasil’s main office meant his meeting with the bank’s lawyers would have to take place elsewhere. The fraudsters took him to a serviced office block that Sao Paulo police later revealed to be a notorious scam hotspot. Mr Pearson eventually became suspicious and called in forensic investigators, who called the bank and were told Langbar’s account didn’t exist. Trading in the company’s shares was suspended and the scheme quickly collapsed. Following a six-year investigation, Mr Pearson was the only person charged by the Serious Fraud Office; he was sentenced to a year in jail.

Lessons learned: Stock fraud will always exist in some form or another and it’s very difficult for retail shareholders to protect themselves against it. Yet, from the beginning, there were enough red flags to dissuade conservative investors from going anywhere near Langbar; the old adage – ‘if it sounds too good to be true, it probably is’ – frequently rings true when investing in small-cap companies. As a rule of thumb, it’s safer to steer clear of businesses where you have to simply take management at their word or that are difficult to easily verify independently.