AIM (formerly the Alternative Investment Market) was established in 1995 and is London Stock Exchange’s market for 800 small and medium size companies, ranging in market capitalisation from less than £1 million to over £2 billion and collectively valued at £85 billion¹. AIM is home to a wide range of dynamic businesses, including several well-established companies that are leaders in their field and have grown to become household names, such as Fevertree, Jet2.com and YouGov. AIM offers a number of attractions for private investors, including exposure to growth companies and the ability to mitigate Inheritance Tax. Significantly, most AIM shares qualify for Business Relief and if held for a minimum of two-years (and at the date of death) qualify for 100% exemption from Inheritance Tax.

The last 18 months has been a difficult period for AIM as a war in Europe, surging energy prices and roaring inflation combined to take their toll on financial markets. As a result, UK smaller companies have been shunned by investors, with valuations impacted by rising interest rates and sentiment towards domestic stocks weighed down by a deteriorating economic outlook. Consequently, the asset class has suffered significant redemptions. The extent of the outflows is highlighted in the chart below, with open-ended UK smaller company funds shrinking in value from over £20 billion to £11 billion, following a c.35% decline in asset values combined with £1.9 billion of net redemptions².

Image 1: UK Smaller Companies – fund flows drive returns

Due to the illiquid nature of smaller companies, the impact of inflows or outflows is often amplified, leading to greater short-term volatility. Since October 2021, when the outlook for inflation changed, UK smaller companies have suffered a period of significant under-performance against the Main Market (from 31/8/21 to 30/6/23 the FTSE 100 increased 5.8% whereas the Numis Smaller Companies + AIM Excluding Investment Companies Index declined 30.6%³). As a result, UK smaller company valuations look attractive with the asset class trading on sub 12x forward earnings, representing a material discount to historic multiples⁴. 

Image 2: Valuation of UK small caps

Whilst we caution that past evidence isn’t necessarily a guide to what may happen next, there is a good chance that we have passed the nadir and we believe this represents an excellent entry point for long-term investors. After UK small caps reached similar levels during both the dotcom bubble and the Global Financial Crisis, the asset class delivered strong returns over the subsequent one, three & five year periods³.

Performance of UK small caps* after equity market corrections

* Numis Smaller Companies Index + AIM (excluding Investment Companies)³

Whilst rising inflation and interest rates have impacted consumer confidence, corporate profitability remains resilient. Estimates from Peel Hunt project that earnings for AIM companies will increase by 11.0%⁴ in 2023. This compares favourably to UK large caps where earnings are forecast to decline by 6.9%⁴ over the next 12 months. 

An example of a stock that has been sold-off is Gamma Communications, a leading provider of telecommunication and IT services to UK and European businesses. Even though adjusted earnings have increased by 40%⁵ since 2020, Gamma’s share price has halved from its £23 peak value in September 2021 to the current £11.50 share price and the earnings multiple (P/E) has fallen from 35 to 15 times. Whilst recognising that the ‘rate’ of growth has slowed, the strong organic growth highlights the strength of the business model which has more than offset inflationary pressures.

Although investor sentiment towards UK equities remains poor and there has been significant selling of UK companies by institutions under liquidity pressure, other participants have been buyers. Companies are repurchasing their own shares at substantial levels, which is testimony to the strength of corporate balance sheets. As highlighted below, there has also been a resurgence in takeover activity over recent months with both private equity (PE) and corporate buyers willing to pay significant premiums for UK equities, highlighting the inherent value.

UK takeovers⁶

In these uncertain economic times investors can easily be concerned by the degree of volatility and seek safety in lower risk assets. However, despite recent set-backs, smaller companies have achieved substantially higher returns than large-caps (and most other asset classes) when measured over the long term. Since 1955, the Numis Smaller Companies Index excluding Investment Companies (NSCI XIC), which measures the performance of the bottom 10% of the UK equity market by value, has delivered a compound (capital only) return of 14.2%⁷, materially outperforming other mainstream UK asset classes. Put another way, due to compounding, £1 invested in UK large companies on 1 January 1955 would be worth £1,255 on 31 December 2022, whereas £1 invested in smaller companies would be worth £8,326 - nearly seven times more⁷.

Image 3: Annualised returns of UK asset classes

This outperformance can be attributed to three key factors: 

• Firstly, the law of diminishing returns dictates the growth rate for a business must slow as it gets bigger (elephants can’t gallop) and it is easier to grow at a faster rate from a lower base.
• Secondly, smaller companies tend to be more agile and can innovate & adapt much quicker than larger companies.
• Finally, smaller companies have a greater bias towards new economy or growth sectors with, for example, the technology sector representing 12.4% of the AIM Index compared to just 1.4% of the Main Market¹.  

Following a gloomy 2022, there are reasons for optimism with the UK economy proving more resilient than previously feared. UK GDP is estimated to have grown by 0.1%⁸ in the 3 months to March 2023 and whilst still elevated, inflation has peaked, leading to talk of a ‘soft landing’ with the Bank of England no longer expecting the UK economy to fall into recession⁹. Whether the UK suffers from a recession or not is difficult to call. However, based upon previous downturns we believe sentiment towards smaller growth companies is overly pessimistic and current valuations are highly attractive.

Sources:

¹  London Stock Exchange, May 2023
² The Investment Association, April 2023
³ Numis Indices
⁴ Peel Hunt UK Market Valuations, 19 June 2023
⁵ Gamma Communications 2020 & 2022 Annual Accounts 
⁶ London Stock Exchange
⁷ Numis Indices: 2022 Annual Review
⁸ Office for National Statistics, May 2023 
⁹ Bank of England Monetary Policy Report, May 2023 

About Whitman Asset Management

Whitman Asset Management is a privately owned and independent discretionary investment management business. Whitman advocate a traditional approach to client relationships with an emphasis on personal service combined with a modern approach to investment management. We offer a personalised discretionary portfolio service with a bias towards global equities within a multi-asset class framework. In addition, we have an AIM IHT portfolio service managed by an experienced team with a proven track record. For investors that like to make their own investment decisions we have a committed execution only desk.
Whitman know that investment management is only one part of the investment process and we strive to work with likeminded professionals to provide the best outcome for clients. We are committed to being investment led and have no internal financial planning arm. Unlike the increasingly monolithic investment management industry we want to remain focused on service and investment performance.

Disclaimer: Although Whitman uses all reasonable skill and care in compiling this report, no warranty is given as to its accuracy or completeness. The opinions expressed accurately reflect the views of Whitman at the date of this document based on our views at such time regarding market conditions and other factors, may depend upon assumptions or projections that may not prove to be correct, and are subject to change. The opinions stated are honestly held, they are not guarantees and should not be relied upon. 

The value of investments may fall as well as rise and your capital is at risk. Information on past performance, where given, is not necessarily a guide to future performance. We strongly recommend that you seek professional advice before you consider making investments is such securities. AIM has less stringent rules and AIM company shares may be less liquid than those companies listed on the London Stock Exchange.

Current tax rules and the available tax reliefs offered on investments into AIM-quoted stocks may change at any time, and there is a considerable risk that if the legislation changed in respect of these tax reliefs, then those stocks that no longer qualified for such reliefs would be subject to heavy selling pressure, potentially leading to significant investment losses.