Filed under: Small Cap Investing
Small Company Investment - Penny SharesWhen I was a child we were fortunate enough to live near acres and acres of countryside which presented a small boy and his friends endless possibilities for adventure and mischief. My particular set of friends were always building dens, one particular den took us months to carve out of mud under a huge mass of bushes and trees, but the finished job looked like a home fit for a Hobbit. It also happened to be not to far from a small orchard, the owners of which also grew vegetables in their gardens.
Our favourite pastime was scrumping apples and potatoes and taking them back to the den where the apples would be the entre and the potatoes wrapped in foil and thrown on a fire were the most amazing main course…. for a 10 year old adventurer. Of course sometimes we would get caught, sometimes the potatoes were rotten and sometimes we went hungry, at least until tea time. Of course Karma comes to visit eventually, we have an apple tree in our garden and neighbors with children. Our crop is not what it should be..
The reason I romance about about this is that in the investment marketplace there is excitement, of course there is, but rarely do we experience the absolute thrills that we did as kids. The nearest we get is making a huge profit on an investment, a risk we took that turned out right. The financial equivalent of scrumping and no place is better to do this than the small cap market.
Yes, there are a lot of rotten apples out there, but when you manage to find a good one that returns huge money, there is, in my opinion, nothing like it. Image you had invested $10,000 in Wal-Mart in its IPO in 1970, you would have $130,000,000 now. Southwest Airlines would have returned (at its high) $2.7mn on the same investment. $10,000 in Dell Computers as late as 1990 would be worth $6mn and I do not even want to do the numbers on Buffets money machine, Berkshire Hathaway.
In the UK in recent years Asia Energy would have been a ‘10 bagger’ in less than three months and there are many, many other companies that would have returned this and more. The incentive to invest is there, that is for sure, but it is a market place that inspires risk takers and also instills fear into investors. The only thing to fear, however, is not “fear itself’ as FDR said but yourself. That’s right, in this market place you need to fear yourself. The propensity to believe every rumour, watch and believe every bulletin board post and trade accordingly will almost always lose you your small cap investment stake and that would be a shame because it can be very rewarding. You need to approach the market place with discipline and with a strategy.
So how does one trade penny stocks? Are there any techniques that work best? Technical analysis that uses indicators and statistics to forecast price movements is one possible approach. However, trading small stocks has, for the most part, been shunned by the technical analysis community. Volumes of less than 400,000 to 500,000 shares a day make analysis unreliable and liquidity a challenge for trading any size. So what do you rely on?
Traditional research is always the best start if you are looking to be a long term player in the field and these days, with the advent of the Internet, there are many helpful sites that aid you in this task. But, by the nature of the reporting rules, you will be behind the curve on historical numbers, with a Blue Chip this is not really problem (unless it is an Enron situation) because if a company made €50mn last year you can be pretty sure that they are not going to go bust by looking at the accounts (assuming they are true, of course). But with a small cap who may have had €1mn in cash in last years accounts and earnings of €5mn, there are various factors that could have wiped the cash out and killed the earnings. There is also a chance that their earnings have gone to €20mn….
So looking at the company accounts is a first, but with small cap shares there is more work needed to be done on the sector. Do they have a good product? Is it reviewed by anyone, anywhere. Could you speak with a client of the company and ask their thoughts on the target company’s product. For me, one of the biggest things to look at is management. Many a smaller company with a fabulous product, a growing client base and a good position in the market place has gone bust because the management were outgrown by the success of the business, and they screwed it up.
At the height of the Internet Bubble (Version 1.0) I was at a meeting called ‘First Tuesday”, you may have heard of it. It was, basically, a get together of investors and Internet entrepreneurs with the concept of putting money and ideas together. At this meeting was a presentation by Boo.com who were discussing their version of world domination and how they were spending the millions they had just raised.
When one of the management team had finished speaking he introduced a lady who was part of the team and part of that introduction was “she is so good we fly her into the UK from LA every week”. I turned to my business partner and said “Lets go”. My premise being that nobody in the world is good enough for a start up company to pay for, conservatively, $20,000 per month of flights to come to work. If she is that good they should have made her come to London to live and if she was that dedicated to making the business a success she would have made that commitment.
True enough Boo.com disappeared shortly afterwards after having spent £80mn of venture capital and also leaving £12mn in debt. Management and their commitment are a critical part of investing in a small cap. This doesn’t mean that they have to be industry gurus and well known names, in fact sometimes this makes me suspicious. I look up how many directorships they have, if they have 20 or 30, what do they care if the one you are about to invest in goes wrong?
My favourite type of manager is one that works in the company 24/7, who has a big enough financial commitment to make it hurt if it goes wrong and make a difference to his life if it goes right. One who knows the sector he is in, inside out, and who has the forethought to have taken on others in his management team that have the same commitment. In the necessary due diligence meetings when hard questions have to be asked, I love it when a CEO gets annoyed with me criticising his business model. I have had CEO’s visibly shaking with rage because I questioned their plan in some shape or another. Those guys are the ones we back.
Also a CEO needs to keep his investors up to date through regular press releases or RNS announcement. I absolutely abhor management who do not keep communication up with their shareholders, good or bad, it is arrogance and insulting and a guaranteed path to failure. I spoke with a CEO years ago on the subject and gave him my speech over dinner about how this element of running a listed company is critical, his response? “I will look after the business, the share price will look after itself”. He is no longer CEO of that company, or any other.
Another element of making good money in this space is by watching the rumour mill. This is extremely risky but can pay off huge dividends. These days there are a lot of people who use bulletin boards such as ADVFN and Moneyam. Yes, there is an abundance of ‘rampers’ who post all sorts of drivel about how this company will be 500% by this time tomorrow and those who say the company is going bust (hoping to gain from shorts) so you have to be careful. But they are worth looking at because some posters give an excellent insight into companies. If you are looking for a site to use I would recommend Motley Fool, the community is very good and the administrators of the site try to cut out most of the rubbish.
As a company we look for companies where we can gain an investment on behalf of our clients through the discretionary managed accounts that we hold. We look to structure investments as convertibles, discounted equity issues and warrant strategies. This puts us directly in the firing line of the research we mentioned above, yes we have more access to information than the average investor, we typically look to invest no less than £250,000, but you can be sure we are lurking on the same bulletin boards you are… scrumping, just like the old days, except this time it is for profits, not potatoes.
Filed under: Small Cap Investing
Under the AIM Rules, an AIM company must appoint and retain a Nominated Adviser (or “Nomad”) at all times. The Nominated Adviser is responsible for confirming to the London Stock Exchange (“LSE”) that the Company is suitable for AIM. This is an important role as the LSE does not itself examine whether an individual company is suitable for AIM, and, instead, it delegates the task to the Nominated Adviser, which becomes the Company’s point of contact with the LSE. After Admission, the Nomad will have an ongoing role to help and guide the Company on the application of the AIM Rules.
Broker
The Company must also appoint and retain a Broker. This may be the same firm as the Nominated Adviser. The Broker is responsible for managing dealings in the Company’s ordinary shares.
Lawyers
Together with the Nominated Adviser, the Company’s solicitors will assist the Board of Directors to ensure that the Company is ready to join AIM. For example, the solicitors will consider the corporate structure of the Company and its subsidiaries and whether it requires any form of group reorganisation. They will also undertake due diligence and provide a report, on Admission, to the Company and the Nominated Adviser,which (along with the Reporting Accountant’s long-form report and/or working capital report) will assist the Nominated Adviser in enabling it to recommend the Company to the LSE.
They will also be involved in the verification process and assisting the Nomad in drafting the Admission Document, and other ancillary documentation.(b) the Nominated Adviser will also appoint another firm of solicitors to review the Admission documentation on its behalf and draft the placing agreement.
Reporting Accountants
The Company’s accountants (or a firm of chartered accountants nominated by them) will undertake thefinancial due diligence, and will assist the Directors in their working capital review.
Other Advisers
In preparation for Admission, the Company will also appoint a registrar, PR consultants and, if necessary, printers.
Our Role
Our Company acts as a buffer between all these advisors. We can select a Nominated Advisor and others if required.
We liaise with these advisors on your behalf, negotiating fees and general management of the whole process.
PREPARATION FOR ADMISSION
There must be no restrictions on the transferability of the Company’s ordinary shares, and, as part of due diligence (see below), the company’s solicitors will review the Company’s constitutional documents (e.g. its articles of association) to ensure that its ordinary shares are freely transferable with effect fromAdmission and eligible for electronic settlement.
The Nominated Adviser and the Company will consider the composition of the Company’s board of Directors, especially the number of non-executive directors. As the Company is being admitted to AIM, it is not required to comply with the Combined Code on the Principles of Good Governance and Code of Best Practice (the “Combined Code”). However, it is recommended that, as a matter of good practice, AIM companies should follow the same core recommendations relating to corporate governance.
Among other things, the Combined Code requires the board of Directors to establish committees of non-executive directors to deal with audit matters, executive remuneration and nominations to the board, and the Company should therefore seek to ensure that there is a sufficient number of non-executive Directorsto meet these requirements.
The Directors’ service agreements should be in writing and their key terms will be disclosed in theAdmission Document. As a result, it is normal for all Directors’ service agreements to be reviewed during the preparation for Admission.
Finally, the Company’s advisers will be carrying out due diligence, which is basically an information gathering exercise but is also intended to expose any commercial messes or skeletons in the cupboard which would have an impact on the pricing of the Company’s shares. The results of the due diligence will allow the Company’s advisers to prepare a high quality Admission Docuement for the purposes of marketing as well as ensuring compliance with the AIM Rules and minimising any liability for the Directors in relation to its content.
Firstly, on the legal side, the Company’s solicitors will carry out anextensive investigation of the Company’s business, including its ownership of its assets and property(including intellectual property), its employment and pension policies, the validity of its ordinary shares, any material contracts and any current or threatened litigation. Secondly, if required, the Reporting Accountants will look at the Company’s financial affairs with a view to preparing, if required, a long-formreport. The long-form report generally describes the history of the business over the last three years and specifies any areas of concern for the Nomad.
KEY DOCUMENTATION
The Company must provide the LSE, at least 10 business days before the expected date of Admission, with a“Ten Day Announcement”. The announcement will include details such as the name of the Company, its registered office, country of incorporation, the number and nature of its ordinary shares, whether it will be seeking to raise capital on Admission; the names and functions of its Directors; its substantial shareholders (i.e. those holding 3% or more of its ordinary shares) and the name and address of its Nominated Adviser.
At least three business days prior to the expected date of Admission, the Company must provide the LSE with a completed AIM application form, the first year’s AIM fee and a declaration from its Nominated Adviser confirmingthe Company’s suitability for AIM.
It is at this time that the Company will also submit an electronic copy of the Admission Document to the LSE. As part of the Admission process, the Company and the Nominated Adviser will also enter into a NominatedAdviser Agreement. This will provide for the Nomad’s terms of engagement, its continuing duties to the Company under the AIM Rules, and its fees. Finally, the Company and the Broker will enter into a placing agreement, which will deal with the Placing and howit will be conducted. The Company and (to some extent) its Directors will be expected to provide warranties.
LEGAL DOCUMENTATION
Verification Notes
Verification is the process of checking all the statements of fact or opinion in the Admission Document to ensure that the document is true, accurate and not misleading. Verification is largely undertaken for theprotection of the Directors who will ultimately assume legal responsibility for the document. In the UnitedKingdom, verification generally involves a line by line analysis of the Admission Document with full verification notes, containing questions produced by the Company’s solicitors covering every line of the document together with answers received from various personnel in the Company.
Representatives of the management team of the Company will have a significant role in working with the Company’s solicitors on the verification of the document, and a point of contact within the Company should be nominated at the outset.
Directors’ Power of Attorney
Once the Admission process is nearing completion, the timeline may mean that there can be no delay caused by the absence of a Director. It is therefore usual for each Director to execute a power ofattorney authorising one of his fellow directors to sign, on his behalf, any document required under the Admission process (including the Admission Document).
Responsibility Letters
While the Directors will sign the Verification Notes, it is also usual for the Directors to sign a letter acknowledging their responsibility for the Admission Document, and any other document, advertisementor announcement published in connection with the Admission.
Memoranda on Directors’ Responsibilities
The Company’s solicitors will provide two memoranda: the first covering the Directors’ responsibilities in relation to the Admission Document (including civil and criminal liability); and a second covering the continuing obligations and responsibilities of the Directors under the AIM Rules, following the Admission of the Company.
Lock-in Undertakings
If it is decided that the Company has had, as its main activity, a business which has not beenindependent and earning revenue for at least 2 years, all “related parties and applicable employees” willbe asked to enter into written undertakings agreeing not to dispose of their shares for a period of at leastone year from the date of Admission. A related party, for these purposes, will include a director of the Company’s group or a substantial shareholder (holding 10% or more of the shares). Even for companies which have been revenue earning for 2 years or more, it is common for the Nomad to seek lock-ins toprovide comfort to new investors or the market as a whole, that the key drivers behind the Company demonstrate their commitment to the Company.
Long Form Articles of Association
Finally, it is usual for the Company to adopt a new set of long form articles of association suitable for a public listed company.
ADMISSION DOCUMENT
Under the AIM Rules, the Company must produce an Admission Document which, subject to specified exceptions, contains information equivalent to that which would be required by the Prospectus Rules published bythe Financial Services Authority from time to time (the “Prospectus Rules”). The Admission Document must contain all such information as “the Company reasonably considers necessary to enable investors to form a full understanding of:-
(a) the assets and liabilities, financial position, profits and losses and prospects of the issuer of thesecurities for which admission is being sought;
(b) the rights attaching to the securities; and
(c) any other matter contained in the Admission Document.” (e.g. material contracts/related party transactions)
There will be a responsibility statement on the front cover of the document to the effect that: “to the best of theknowledge and belief of the directors (who have taken all reasonable care to ensure that such is the case) the information contained in the Admission Document is in accordance with the facts and does not omit anything likely to affect the import of such information.”
The above information has been taken, in part, from Charles Russell .
Charles Russell is one of the leading legal advisors to both companies listing on AIM and brokers/NOMADs in relation to AIM transactions.
