From the Coalface: small caps poised for a comeback?

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From the Coalface: small caps poised for a comeback?
Master Investor Magazine

Master Investor Magazine Issue 58

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Small caps are certainly poised for a return to the limelight, and more generally 2020 feels like it is going to be a better year all round, writes Claire Noyce. 

The glumness that plagued the market in 2019 can still hold sway, or we can all be more positive and upbeat this decade – and yes, it is a new decade and I won’t be drawn into mathematical deliberations about whether we need to wait another year for the new decade.

It feels like a new decade: the Tories won a landslide victory and we finally got some level of certainty regarding Brexit; and the markets had a welcoming “Santa Rally”, leaving us all with a sense of optimism and a time to reflect on where this all leaves small caps and the UK market.

Yes, AIM has the lowest number of companies on market since 2003. Indeed, the bears would frown at the fact that the number of companies on AIM stands at just 863 – not to mention that IPO activity has all but dried up, with a meagre 36 companies going public on the LSE (AIM and the Main Market) in 2019, raising just £4.4bn.

Meanwhile, the bulls would take great delight in the fact that AIM has gone through an intense period of ‘natural selection’.  Many of the lifestyle companies that plagued AIM have fallen by the wayside and some of the advisers that helped prop them up for several years have also disappeared.

We believe this leaves a collection of more stable companies, but some may associate stability with potentially lower growth prospects.

However, we applaud the companies that have weathered the storm and not raised any money at eye-watering discounts, but instead tightened their belts, preserved cash, and pressed on.

As most public equity participants are still licking their wounds from last year, private equity fundraising in Europe set a record in 2019, raising an eye watering $342bn. We would expect to see holding patterns last longer in the PE space going forward as PE-exited IPOs remain largely out of favour (think of the performance of, say, Aston Martin (LON:AML)).

However, with cashed-up PE behemoths salivating in the bush ready to pounce upon lame public companies with depressed valuations, a predatory M&A year would not be surprising. This wouldn’t be confined to the PE space either – Anglo American (LON:AAL) recently made a painstaking 5.50p per share offer for Sirius Minerals (LON:SXX). Just two years ago they were touching 40p!

In 2020, we are already out of the starting blocks, with the Nippon Active Value (LON:NAVF) fund being the first IPO of the year raising £200m at 100p per share. The fund will invest in quoted Japanese stocks with market caps of up to $1bn. The Global Sustainable Farmland Income Trust is also rumoured to be planning a $300m London IPO to invest in farmland around the world. Apart from these two, we are yet to see others stick their head above the parapet, but it is only the first week back.

For companies weighing up the prospects of an IPO, there are lots of reasons to be optimistic. For qualifying companies, the amount invested in VCTs reached its highest in more than a decade in the tax year 2018/2019 (£716m). With less new entrants coming on to the market and on-market companies often no longer meeting the requirements for VCT relief, competition for capital is fairly low right now.

To typically qualify for tax relief, companies must receive investment within seven years from their first commercial sale. If you are deemed to be a knowledge intensive company, that time limit is extended to 10 years.

Despite this, it won’t all be plain sailing. There will be bumps along the way. On the one hand, if the deal flow that comes their way on AIM is not up to scratch, VCTs will continue to hold off on AIM investing and look towards the private sphere for opportunities. On the other hand, with valuations depressed on market, what rationale is there for an institutional investor to pay 10X EBITDA on a new company in an IPO investment with added risk, when they can pick up a company that is already listed for half of that with an added bonus of a quote, a track record and a reputation?

In November 2019, an SME valuation index was produced by the UK200 Group and MarktoMarket showing SME EBITDA multiples averaging 6.1X in 2019. Surprisingly, there was little change on this over the last three years despite the deepening political uncertainty. With investors no longer in the mood as they were previously for a “cha cha cha” and dialogue on valuation, companies only have one shot to put their best argument forward and shouldn’t cut off their nose to spite their face given the data above. It is still a buyer’s market, whether we are talking stocks and shares or property.

In the secondary markets, investors will continue to mete out punishment to companies issuing profit warnings. For instance, the last three years saw many a small cap suffer from major contracts being delayed rather than cancelled. Now with some political certainty in the air, we hope to see blue-chip companies opening their purse strings again and buying goods and services off SMEs which should equate to RNSs and share price appreciation.

As we look towards possible trends for companies coming to market in 2020, the annual global tech gathering in the US at the CES Show where all the tech giants go to display their latest toys is usually a good starting point. However, with driverless car tech continuing to be all the rage, we would not expect those trends to hit AIM anytime soon.

A more realistic exercise is to look back a couple of years on which companies tried to IPO off the back of a “sector buzz” but unfortunately failed to raise money as they didn’t have any customers or revenues to speak of. Blockchain could be a prime example. Two years down the line, one would hope numerous customer trials have gone through which have progressed into paying contracts. As digital transformation remains to be a key topic for many organisations, blockchain could be construed as a key enabler to this switch.

Cybersecurity will remain a key theme and we would expect to see new companies emerge to cater for the everchanging threats posed to companies, or indeed existing companies developing in-house products to constantly keep up with the pace of change. With constant regulation such as GDPR, the cost of “getting it wrong” has never been greater, so we wouldn’t expect big IT budgets to be going south anytime soon in that area.

Could the Roaring Twenties make a come-back a century later? Investors have been generally underweight the UK for a number of years, and we would expect that to gradually improve as the confidence comes back into the markets.

Small caps are certainly poised for a return to the limelight, and more generally 2020 feels like it is going to be a better year all round.


A new regular addition to our blog, “From the Coalface” is penned by Hybridan founding partner and CEO Claire Noyce. Each month, Claire will be updating readers on all the latest developments from deep within the heart of the City.  

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