AIM – reasons to be optimistic

The UK small-cap sector has been hit particularly hard in recent years by a combination of macroeconomic factors and seemingly increasingly pessimistic views on the prospect of conducting business here. However, there are several reasons for optimism among investors and, as Albert Einstein said, in the middle of difficulty lies opportunity.

Rising interest rates in response to the return of high inflation has been the chief cause of weakness in the small-cap sector, specifically the AIM (Alternative Investment Market). Many companies we own have net cash and higher interest rates mean that future cash flows are assigned a lower value in a discounted cash flow model.

Smaller firms are often left more exposed to restrictive monetary policies than their large-cap peers and tend to underperform in unstable environments. There are many ways that instability can adversely impact smaller businesses to a greater degree - rising wages, typically a larger share of floating-rate debt, smaller cash buffers to ride out slower periods, and so on.

While performance has been challenging in recent years, investors should not lose sight of the three reasons to be optimistic:

1. Improving macro

The rate hiking cycle in the UK is now approaching its end. Fourteen consecutive interest rate hikes from the Bank of England in a little over 18 months represents one of the fastest tightening cycles on record and has unsurprisingly weighed on sentiment. There is some light at the end of the tunnel though and a growing consensus that we are closing in on, if not already at, the end of the rate hiking cycle.

The rapid rate rises were an attempt to curb the highest level of inflation in a generation and while price pressures are still running well above central bank targets, there has been an improvement on this front of late. The consumer price index (CPI) fell to 6.7% annually in August, its lowest level in over a year and down significantly from a peak of 11.1% in October 2022.

2. Excessive pessimism

High inflation and sharply rising interest rates have led to a more downbeat mood in financial markets since the start of 2022, particularly concerning small-cap stocks. There are two ways that major changes in the macroeconomic environment can cause stock prices to decline; a fall in earnings and a drop in the value the market assigns to those earnings – also known as de-rating or multiple compression. Although earnings in the AIM space have suffered from the change in backdrop, the greater impact has come about due to these earnings being assigned a lower value.

Although some of these concerns are well founded, the size of the decline suggests a fairly extreme level of pessimism. Price/earnings multiples in the small-cap space have dropped to their lowest level in several years and are currently well below the 20-year average. There is already a lot of bad news in the price and, should sentiment improve on less bad news going forward, current levels offer attractive entry points into a number of high-quality AIM stocks.

3. Good companies

The key to long-term success as an investor is to buy high-quality stocks at reasonable prices. As is often the case in sizable market declines for the broader market, the overarching narrative has been largely pessimistic. However, there have been several success stories during this time, with stocks such as Jet2 and Johnson Services enjoying good runs higher. This demonstrates the value of active management, especially when overall market conditions are challenging. The ability to pick the best stocks and avoid those struggling is often worth even more in a sideways to down market.

A key factor we look at when assessing a company’s prospects is the CEO/management. As the highest-ranking person in the company the quality of the CEO is an important consideration for all companies, but the role is often even more important for smaller firms as their ability to influence outcomes is greater. Two of the first things we look at when assessing a CEO is whether they adopt an analytical approach and if they have a deep understanding of the business’s key proposition. The CEO role is clearly complex and multi-faceted, but if they are applying rational analysis and are focused on delivering or improving what matters most to the business and the end customer, then that’s definitely a good sign.

So, is now a good time to invest in the AIM?

In addition to these points, fiscal policy changes have enhanced one of the longstanding potential benefits from investing in AIM – reducing inheritance tax (IHT). The government announced last year that inheritance tax thresholds will be frozen until at least April 2028, two years longer than previously communicated.

This will see more estates exceeding the nil rate band of £325,000 as a result of rising asset prices, increasing the draw of the tax-efficient nature of AIM investments. Certain AIM shares qualify for IHT exemption via business property relief if they are held on death, and have been held for two years prior.

Although we believe investing is for the long-term and there are several real positives outside of the IHT treatment, this can add an additional appeal for those looking to minimise tax liabilities and ensure as much wealth as possible can be passed through the generations.

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This communication does not constitute a recommendation. This material is not tax, legal or accounting advice and should not be relied on for tax, legal or accounting purposes. Quilter Cheviot Limited does not provide tax, legal or accounting advice. You should consult your own tax, legal and accounting adviser(s) before engaging in any transaction. Investors should remember that the value of investments, and the income from them, can go down as well as up and that past performance is no guarantee of future returns. You may not recover what you invest. The securities and investments within this document may not be suitable for all recipients. The appropriateness of a particular strategy will depend on an individual’s circumstances and objectives.