Shares digital

Carlo Svaluto explains how investors can turn pennies into pounds with some shrewd investments in fledgling firms

In 1992 Cairn Energy was just another struggling Scottish prospector for oil and gas in the North Sea and Texas. A discovery in Rajasthan, northern India, looked to hold some promise but partner Royal Dutch Shell was not impressed. Some 10 years later, Cairn bought Shell out for £7 million, stepped up its drilling and in early 2004 saw the first of more than 20 discoveries in Rajasthan block RJ-ON-90/1. Cairn has since spun off a 35% stake in its Indian operations, developed businesses in Bangladesh and Nepal and acquired assets in Albania, Australia, Tunisia and Peru.

This dramatic change in fortune has seen Cairn’s share price power ahead from 21p in 1992 to £27.40. To hit such a jackpot is every investor’s goal. Such giddy ascents are rare but penny shares can still generate fabulous returns even without such a vertiginous rise through the ranks. In the last month alone, video search engine Blinkx, silicon wafer treatment expert Pure Wafer and oil and gas explorer Forum Energy have risen by 87%, 83% and 78% respectively.

Despite the testing nature of equity markets overall in 2008, gains such as these mean investor appetite for penny shares is undimmed. An exclusive survey – conducted with the users of 'Shares' sister website www.moneyam.com and Shares readers, in partnership with The Share Centre – gives a unique insight into why small caps remain so popular. And to help point investors in the right direction, Shares has identified five penny stocks to generate rich pickings from your pocket change.

Pennies into pounds

Aim is the spiritual home of the UK’s ‘penny’ shares, which for purposes of this exercise are defined as stocks with a market capitalisation below £50 million and a share price below 50p. A wide bid-offer spread, often in excess of 10%, can characterise these companies, although this has not been insisted on.

In conjunction with The Share Centre, Shares and Moneyam have asked investors for their views on Aim. The results clearly reveal small cap profits remains a key goal with the nation’s market punters.

Guy Knight, sales and marketing director at The Share Centre, says: ‘When I dug a bit deeper into the results of the survey, I realised many respondents are likely to be affluent, and therefore they have assets that can be invested in riskier adventures.

‘We were surprised at how positive the attitude towards Aim investing is. I felt the respondents were very honest. They don’t pretend Aim is not risky. However they show strong confidence in this investment strategy and this is reflected by their intention of keeping their Aim holdings.’

Key findings from the survey were as follows:

Aim as popular as ever with private investors. The survey reveals 66% of all respondents own shares in Aim-listed stocks. This compares with 15% who invest solely in main market shares.

Investors want to increase their exposure. The data reveals 15% of investors are looking to increase their exposure to Aim and 65% keep it unchanged despite choppy market conditions.

Growth stocks for capital gains is a central

strategy. Three quarters of the respondents said they invest in Aim because it provides access to smaller companies with shrewd businessmen at the helm and fresh ideas to turn into exciting products in growth markets. Early-stage growth stocks are the best way of making a quick killing, as they offer a chance to clamber aboard at the steepest part of a firm’s growth curve.

The London Stock Exchange has done much to foster Aim since the junior market was founded 13 years ago. A lighter regulatory touch has created an environment perfect for fast and furious small cap punts. In a different fashion from the main market, companies listing on Aim have no need to demonstrate three years of trading history. There is no minimum limit for their size or market capitalisation when they list, and nor does a minimum of 25% of the shares outstanding have to be in public hands after the flotation.

This freewheeling culture has, however, resulted in some spectacular accidents – notably cash shell Langbar. The cash shell was hit by a scandal in 2005 when it was found it did not hold the £350 million of cash it claimed it had. More recent examples of stocks falling to earth with a terrible thud include Tanfield, Central African Gold and Loanmakers Holdings – all of which have fallen by more than 70% this year. Electric vehicle maker Tanfield issued a profit warning in July after its aggressive expansion plans came unstuck, Central African Gold suffered when what it termed ‘accounting complications’ delayed the publication of its books for 2007 and Loanmakers is one of many financial services firms whose business model has been hit by the credit crunch.

Plunges such as these prompted the Securities and Exchange Commission’s Roel Campos to last year claim most Aim firms would be gone within a year. Campos allegedly labelled the market ‘a casino’, a claim he later denied.

Such criticism is unmerited. The LSE has introduced rules which tightened up on the way cash shells operate, insisted on resource firms providing regulator progress updates and enhanced transparency and disclosure by insisting all Aim-listed firms must have a website and report under the auspices of the International Accounting Standards (IAS).

Aim has also proved self regulating. After a torrent of Initial Public Offerings in 2006 and 2007 (when 462 and 284 listings respectively took the number of Aim floats since the market’s foundation to 2,948) 2008 has seen just 43 companies go public. Investors have become more selective and the dross is simply not being allowed access to equity capital. The one possible exception is oil exploration firms, where, as noted by Shares (24 July ‘08 and 31 July ‘08) the rising oil price tempted some to grab some cash while they could. This is reminiscent of the dash by Indian and Chinese firms to list in 2006 and 2007 – when a total of 69 firms came to the London junior market – only for them to call the top of their local bourses perfectly and lose investors their shirts in 2008.

‘The survey suggests Aim does not constitute 100% of the respondents’ portfolio,’ says Knight. ‘These are people that are not falling in love with their shares, as long-term investors may sometimes do. The respondents of the survey apply stop losses, and they take a slightly detached view. In other words they have a cold, calculated attitude.’

Knight believes this is the way to go about investing on Aim. ‘This is the right attitude to have as a private investor,’ he says. ‘The respondents seem to be very realistic about what they are doing.

‘They know that they can make strong gains in the short to medium term but at the same time they accept they are going to lose money at times. In fact a lot of them are losing money at the moment, and most of them recognise Aim investing is risky.’

Key concerns:

Under such circumstances, it is not surprising the Aim Survey does see the respondents outline three key concerns.

Liquidity. Aim shares are not as liquid as those traded on the main market. This illiquidity can result in wide bid-offer spreads, which mean an investor often needs a share price to rise by 15 to 20 per cent for even a small profit after dealing costs. Not surprisingly, 30% of those who replied said they find it difficult to trade the quantity of Aim shares they wish to.

Tax breaks should be reinstituted. Tax advantages were always a key attraction of investing on Aim. However, Chancellor of the Exchequer Alistair Darling tampered with Aim’s tax benefits when he changed the rules on capital gains tax (GCT) this year, scrapping taper relief for investors who hold their shares for longer than two years. It seems likely the removal of some CGT breaks has not helped sentiment on Aim this year and has encouraged some investors to sell. Not surprisingly, investors are demanding smaller fiscal burdens on riskier investments such as penny shares on Aim. The survey reveals 56% of respondents thinks the government should remove stamp duty on Aim purchases.

Losses suffered in 2008. Equity markets have given no-one an easy ride this year and penny shares investors have suffered more than most. The Aim All-Share index has so far fallen 21.7% in 2008, against a 16.2% decline for the FTSE All-Share and 16.2% for the big cap FTSE 100.

As already noted, Aim has had its share of disasters in 2008: Coolabi, Cyan and Premium Bars & Restaurants are just three companies which shares have plunged by more than 50%. Of course this does not mean losses are exclusively a small cap problem – the now-nationalised Northern Rock was a FTSE 100 company until 12 December last year and investors lost everything there. It has been a hard 2008 and the survey’s respondents were very candid with an assessment of their investments’ performance this year. A sixth of them admitted to having lost between 16% and 30% of their money.

What to look for

These reverses have clearly not deterred investors, since 80% of the survey’s respondents plan to increase or keep their Aim exposure in 2008. The more risk-averse investor could seek exposure to Aim’s treasure trove of penny shares via specialised asset managers, some of whom offer access to Aim stocks and penny shares.

Chelverton Asset Management is a small cap specialist and its Chelverton Growth Trust Vehicle focuses precisely on penny shares with market caps under £50 million. The objective of the fund is to increase net asset value per share at a higher rate than the FTSE All-Share Index appreciates in value.

The price of the investment trust has slumped 47% since the start of 2008 to 21.5p. Chelverton’s UK equity income fund – which focuses on Aim companies for yield as well as capital growth – has also been hit by the general sell-off. Losses were significant as the share price has fallen 23% to 65.3p.

Aim-quoted asset manager Liontrust also runs a vehicle which specialises in the junior market. Its First Opportunities Fund is around 40% invested in Aim stocks. The £10 million fund slightly outperformed the FTSE All-Share over the six months to April 2008, falling by 9.8% against the index’s 10.2%. However, since the fund’s launch in 2005, it has easily beaten the All-Share, returning 25% to the index’s 15.3% rise.

Yet investing in a fund goes against the grain for the classic Aim investor, who likes the thrill of picking their own winners from the 1,657 firms which currently reside on the junior market. That is still a dauntingly long list of names. Shares has therefore drawn lessons from this year’s Aim successes and failures, and also the vital data unveiled by the MoneyAM and Shares survey in partnership with The Share Centre, to help investors pick out the wealth creators and dodge the flops.

Trading history

In a perfect world, investors would have a portfolio crammed with firms which already make a profit but many Aim stocks are in their early development stages. Those investors willing to take on plenty of risk and put their money into firms which have yet to record a profit should at least focus on companies which already have some revenues. The current equity market environment is not likely to be forgiving of blue-sky punts – particularly ones with lofty market capitalisation – and for the moment firms with little or no trading history should be treated with great caution.

Growth market

Firms which operate in growing markets should be targeted. Plenty of these can be identified in the vast penny shares arena, but addressing a growth area is no guarantee of success. The company has to have good products. Fast-moving, consumer-focused gadget markets are notoriously treacherous, as this year’s 86% collapse in high-performance mobile handset maker’s i-mate’s 86% share price collapse attests. Oil exploration companies with unclear prospects in risky environments should also be handled with care.

Well funded

In such an unforgiving debt and equity market environment, it is vital companies do not need to tap the debt or equity markets to get additional funds. A cool reception is likely for any firm which seeks to raise cash now and only the strongest stories will attract fresh money. Well-funded companies should be a focus for investors and the ideal firm is one with net cash on the balance sheet, as this will facilitate funding of day-to-day activities and also future growth plans.

Good levels of disclosure

The presence of 339 international companies on Aim means corporate governance and open disclosure of companies’ dealings are real issues. Rules for listing on Aim established by the London Stock Exchange say companies have to update the market regularly and offer comprehensive websites, although some companies are naturally better at communicating their progress than others.

A classic example of bad disclosure was Regal Petroleum back in 2005 when the oil explorer admitted a much-hyped well in Greece was almost dry, after rising £42 million from institutions. This sent the share price tumbling and it took several years and the arrival of a new management team for the stock to recover the lost ground and its reputation.

Valuation

When scouting for penny shares, investors will come across some fallen giants, whose shares were once valued at much higher multiples only to suffer a fierce de-rating as hard times hit home. Such depressed valuations can provide an entry point in firms with large, established operations – particularly if there is a restructuring story or turnaround program in place. Examples of this include silicon reclamation business Pure Wafer, the shares of which crashed from 285p to 4p after pair of profit warnings, and IT services group Business Systems Group, the shares of which have plunged from 160p to 14p since the technology bubble burst in 2000.

5 penny shares to grow

Shares has used the following checklist to draw up a list of five penny stocks to help investors pile on the pounds:

1. market cap of less than £50 million

2. a revenue track record or at least the business has been launched

3. availability of cash

4. positioning in a sector where earnings growth is forecast

5. bid-offer spread for the shares of less than 10%

Eleco, 75.5p Buy

Market cap: £45m

2009 PE: 7.1

2009 EPS growth: 22%

2009 yield: n/a

Net cash: £2.0 million*

Net gearing: -7.7%*

1m relative strength: -5.2%

6m relative strength: -11.9%

Spread: 6.4%

*As of 31 December 2007

Sentiment on construction firms is still very depressed but the market has it wrong in the case of Eleco. The materials firm has little exposure to the residential housing market, as its products are primarily used instead in publicly-funded projects such as schools and universities. It also has a software business which has started to accumulate decent profits and helped group-wide pre-tax income nearly treble since 2003 to £6 million. Dividend payments have grown consistently and the £45 million cap has net cash in the bank, before a £3.2 million retirement benefit obligation is taken into account.

Even though the shares have bounced from 58p to 75.5p since May, they still stand a third lower than their 112p level of a year ago. The slight premium relative to other construction stocks of 7.1 times 2009 earnings is justified.(CS)

FREEDOM4 Communications, 1.8p Buy

Market cap: £19.8 million

2009 PE: n/a

2009 EPS growth: n/a

2009 yield: n/a

Net cash: £23.3 million*

Net gearing: n/a*

1m relative strength: +5.7%

6m relative strength:-73.9%

Spread: 2.8%

*As of 31 December 2007

FREEDOM4, which is all that remains of Pipex after the sale of its hosting business and April cash distribution, is a classic penny investment: new technology, a business case yet to be proven but terrific potential. Unlike many penny shares it is well funded, with £13 million in cash and a £17.5 million loan note due to be repaid by autumn 2009; the firm intends to distribute proceeds from this repayment to shareholders.

Once the £30 million in cash and loan notes plus £7 million of capital investment commitments are accounted for, FREEDOM4's operating assets are valued at nil. The firm owns 52% of a joint venture with Intel which offers fixed broadband telecom services using the emerging Worldwide Interoperability for Microwave Access (WiMax) technology. FREEDOM4 has already launched its fixed broadband service in Manchester, Warwick and Milton Keynes, which is aimed at small businesses and operates at the 2.6GHz band. But chief executive Mike Read applied for a mobile licence in February and plans to increase his firm's consumer reach in time cannot be ruled out. (RM)

Mediterranean Oil & Gas, 123p Buy

Market cap: £47.7m

2009 PE: n/a

2009 EPS growth: n/a

2009 yield: n/a

Net cash: e12.2m*

Net gearing: 45%*

1m relative strength: -13.4%

6m relative strength: -29.7%

Spread: 6.5%

*As of 31 December 2007

The Italian explorer has, like a lot of small-caps, been punished in the recent market downturn but having already firmed up one discovery earlier this year it promises further potential upside in 2008. The sell off has seen the shares surrender all of the ground made in the wake of a successful appraisal well on the Ombrina Mare discovery. This looks excessive given the significant reserves Mediterranean Oil & Gas has to its name already, courtesy of Ombrina Mare, in which it has a 100% stake. The site has proved and probable reserves of around 20 million barrels.

While this remains the focus for the company Mediterranean is also drilling the potentially high-impact Monte Grosso well before the end of the year. This has a target of up to 13.7 million barrels of recoverable reserves net to the firm. The £47.7 million cap is partnered on the well with industry giants ENI and Total, which reassures on the prospect's attractions. (TS)

Minera IRL, 57.25p Buy

Market cap: £35 million

2009 PE:n/a

2009 EPS growth: n/a

2009 yield: n/a

Net cash: $2.2 million

Net gearing: -10.0%

1m relative strength: -8.2%

6m relative strength: +27.0%

Spread: 3.3%

*As of 31 December 2007

The £35 million market cap joined Aim in April 2007 and then listed on the Lima Exchange in Peru eight months later after extensive exploration work. After a sticky start, the shares more than doubled in the first half of this year. Minera has since been the subject of profit taking – alongside so many of its mining peers – and the stock has pulled back from a high of 75p to 57.3p in the past month. Final results published in late June suggest this is a buying opportunity as the business continues to progress nicely.

The company's Corihuarmi mine in Peru achieved full production in the quarter after being commissioned in the first quarter, and has produced 16,290 ounces of gold which exceeded the company's forecasts by 34%. Extraction work is costing the company $132 an ounce, or 56% below its budget. Gross cash reserves had increased to $5.2 million at the end of the second quarter. All these positives will be reflected in further share price increases. (CS)

Rurelec, 49p Buy

Market cap: £43m

2009 PE: n/a

2009 EPS growth: n/a

2009 yield: 5.2%

Net debt: £17.9 million*

Net gearing: 28.0%*

1m relative strength: -23.7%

6m relative strength: 6.9%

Spread: 2.0%

*As of 31 December 2007

Shares in the Latin American-focused independent power producer slumped in July from a peak of 72p to 48.5p after a £7.8 million capital raising priced at 65p, designed to fund the acquisition of the 50% stake in Argentina's Energia del Sud it did not already own. The sell off looks overdone as May's preliminary results showed significant progress in both Bolivia and Argentina – management was even confident enough to raise the dividend payout by 11% to 2.5p.

Rurelec continues to add capacity at a rapid pace, helped by strong support from its banking partners, which provide non-recourse project debt. Rurelec has also received recognition for its carbon credits and will be able to start trading them as a further source of revenue. In August another plant comes on stream in Argentina, in an area that has suffered from power shortages. (CS)