Everyone loves the idea of a blue-sky punt. It is an investor’s dream to pick up a tiny stock for pennies, maybe a loss-making company beavering away with a brilliant idea, and then watch as its ideas and products catch on, start-up losses turn into huge profits and the stock rises tenfold or more, making you a fortune. The odds against are high but it can and does happen. Under the guidance of Robin Saxby, ARM Holdings (ARM) revolutionised the global silicon chip industry when it developed the fabless and chipless semiconductor model. This means company does not get involved in the difficult and expensive process of silicon chip manufacturing. Instead, it licenses out its processor architectures for a fee and then collects a royalty each time a chip featuring its designs is manufactured. Nineteen years after ARM was spun out of the ultimately-doomed computer company Acorn, the firm still dominates the semiconductor intellectual property (semi IP) market. Following its 1998 initial public offering the shares flew up by 2,320% in their first two years of trading, rewarding those investors who backed the ARM management team’s technological prowess as well as their vision.
Jam tomorrow
Many investors shun the risk involved when buying ‘jam tomorrow’ stocks, which promise huge profits in three, four or five year’s time but in the end often fail to deliver. In his book of 2003, ‘The Innovator’s Solution’, business guru and Harvard Professor Clayton Christensen wrote: ‘Over 60% of all new-product development efforts are scuttled before they ever reach the market. Of the 40% that see the light of day, 40% fail to become profitable and are withdrawn from the market’.
That means just a quarter actually make it to the big time and this risk has to be taken into account when looking for the next Microsoft or Nokia – both of which, it must not be forgotten, had humble origins, in Bill Gates’ garage and as a loss-making Finnish engineering-to-consumer-electronics respectively.
It may seem ever more foolhardy to be looking for blue-sky stocks in the teeth of a recession. But any firm capable of generating earnings growth whatever the economic environment will always be a highly-prized asset. The recent market recovery, which has seen the FTSE All-Share surge into positive territory for 2009, has also seen investors’ once more show an appetite for risk and a willingness to take a chance on a stock making it big. The market plunge seen since 2007 also means many ‘jam tomorrow’ stocks have seen their share prices pounded and market valuations collapse, as investors fled risk and proved particularly wary of smaller firms which were struggling to fund their short-term investment needs. Once-promising prospects such as embedded computer specialist Inova, hand-held device maker i-mate and storage specialist Plasmon have suffered either huge share price collapses or decided to delist or simply failed altogether.
Yet many budding British investment stars are doing just fine, thank you and after two years of stock market falls they could now prove bargain investments.
The rewards
Technology is the area where most investors will look for the next ten-bagger. ARM is certainly sitting pretty with its chips present in 98% of all of the world’s mobile phones, and in spite of the recession putting a damper on the party this is not a product likely to go out of fashion any time soon. Pace (PIC) has seen shares rally nearly 300% this year alone as the manufacturer of digital TV set-top boxes is benefiting from the digital switch-over. Investors should therefore look for punts whose products are easy to use, offer a huge improvement in terms of productivity or quality of service against the
current incumbent product and give the firm a chance to generate high profit margins once past the start-up phase so it can monetise its first-mover advantage.
But there are other parts of the equity market which can also offer money spinning
success stories. Back in 1992 Cairn Energy (CNE) was just another struggling Scottish prospector for oil and gas in the North Sea and Texas, with a few rigs going nowhere fast. A discovery in Rajasthan, Northern India, looked more promising but 50% partner Shell was not convinced. Ten years on, Cairn took the plunge and bought Shell out for £7 million and stepped up its drilling. The rest, as they say, is history. Cairn is now firmly established as a FTSE 100 firm, with oil assets in India, Bangladesh and Nepal and a market cap of £3.2 billion. Those shrewd enough to back the judgement of Sir Bill Gammell, who founded Cairn and was appointed chief executive officer when the firm floated in 1988, have been rewarded with a rise in Cairn’s share price from 193p to £23.48 and a 1,117% return in just over 20 years.
The risks
Running out of money is a common problem for start-up firms which often have to carry heavy research and development (R&D) costs before they generate any sales, let alone any profits. Following an abandoned takeover bid, semiconductor equipment production expert Bede had to call in administrators last year after failing to secure new funding in its efforts to establish industry support for its innovative X-Ray metrology products, despite the presence of industry heavy-hitter Stuart McIntosh on its board. Cash woes, end market volatility and a collapsing share price prompted computer components maker OCZ Technology to leave Aim last month in preference for a US listing. Investors looking for punts must therefore be mindful of companies’ cash burn, and whether their financing, or preferably cash, will keep them afloat through to profitability even if things go according to plan.
Inventing a product that changes or creates a market can be very profitable, presuming customers can be persuaded that they need it - and are willing to pay for it. Eleksen’s failed attempt to develop electronic gadget controls out of fabric proved this point, while Servocell ran out of cash before it could persuade the world its Active Latch electronic locking mechanism really was superior to its traditional electromechanical rivals.
Spotting the winners
‘You need to be extremely mindful of where it can go wrong. If you do that the upside will take care of itself,’ says Justin Jordan, fund manager at Credit Suisse. He points to three characteristics to look for in a growth stock: ‘A company with a niche product or service which means it can grow its earnings faster than the market over a number of years. A company which delivers earnings upgrades. A company and a management team that is being re-rated by the market over time.’
In his final point Jordan addresses the thorny issue of valuation. ARM and unstructured data management specialist Autonomy (AU.) have been fabulous success stories and look set to dominate their respective industries for years to come. Yet neither share is trading within a country mile of the highs seen in 2000 before the technology bubble burst. At 111p ARM stands 90% below its December 1999 bubble high of £10.01 and at £14.59 Autonomy is still way below its November 2000 peak of £34.27, even though both have sales and profits higher than they were nine years ago.
This is because any valuation mechanism has two parts. In the case of the PE it is ‘E’ for earnings for ‘P’ for the price, or multiple, investors are willing to pay to get access to those earnings. After the tech disappointments of 2000-2001, when lofty growth expectations were not met, investors are simply attaching a lower valuation, or ‘Price’, to each company’s earnings stream and cash flow to reflect the risks involved. The shares are said to have suffered a ‘de-rating’ as a result. If the reverse happens – earnings keep surprising on the upside – the stock is perceived as being less risky and it will enjoy the ‘re-rating’ flagged by Credit Suisse’s Jordan.
It is in cases such as these that fortune favours the bold as hype is followed by substance. A strong management team, a product that makes sense, and funding to reach profitability are good places to start. To help investors spot the stars and dodge the duds Shares has analysed five industries which are capable of witnessing the emergence of a new market leader and also highlighted the potential of ten individual firms.
EXPLORATION: Digging for treasure
The examples of Cairn Energy and more recently Heritage Oil (HOIL) will be ones all small companies in the oil and gas exploration sector will be seek to emulate. Given the rewards on offer investors are also understandably keen to identify the next stellar exploration story. Cairn made its find in Rajasthan, Northern India, in 2004, having been accused of 'putting all its eggs in one basket' after selling its North Sea assets. The gamble paid off in spectacular fashion with a billion barrel discovery and as a result the share price increased more than eight-fold between 2004 and summer last year.
In Heritage's case there have been two separate areas of exploration success: Uganda, where the group is partnered with Tullow Oil (TLW); and more recently Kurdistan in Northern Iraq. According to the company the latter discovery, on the Miran block, could yield up to four billion barrels of oil. News of this find has helped drive Heritage's shares up more than 200% in the last six months alone to 552p.
Drilling for oil or gas is a risky business and it is just as easy to lose as it is to make money investing in the companies which operate in this area. But 'blue sky' exploration is likely to have its fans as long as such potentially huge gains are on offer. Falkland Oil & Gas (FOGL:AIM) is our best bet. (TS)
GREEN MATTERS: Ready for takeoff
The credit crunch has hit the renewable energy sector hard. Much of the technology is unproven, the cash-hungry young companies are often not yet profitable and struggle to compete with fossil fuels whose prices have been dropping. But the green stuff has never had stronger political support than right now, as the seriousness of the climate change threat is starting to translate into action – meaning subsidies – so these 'save the planet' inventions can get off the ground.
The difficulty experienced by Tanfield (TAN:AIM) in its efforts to create a commercially-viable zero emissions vehicle illustrates the risky nature of trying to monetise green inventions, however worthy the cause. Others have been more successful, such as Ocean Power Technologies (OPT:AIM), which has benefited from the support of the US Navy in its efforts to create buoys that harness wave power. Fuel-cell group Ceres Power (CWR:AIM) has big brother support from Centrica (CNA), which should see it safely to profitability.
Renewable Energy Holdings (REH:AIM) has its fingers in many pies, with a portfolio of renewable assets such as landfill gas, solar power, hydro electricity and wind power. The fact we live in the windiest country in Europe is a boost for Novera Energy (NVE:AIM). Funding is in place, the development pipeline is strong and the management team has a good track record of obtaining planning permissions – promising signs for any punt. (JF)
IP INCUBATORS: The ideas factory
A good way to spot the bright ideas of tomorrow is to look at Intellectual Property (IP) commercialisation companies. They help people turn inventions into businesses either through financial assistance or consultancy. The market sell-off in the past year or so mean IP companies have swung out of fashion as investors shun high-risks stocks, but as this sentiment changes such stocks could be worth revisiting.
The historic goal has been to nurture a business and float it on the stock market where a stake is either sold or held. With the capital markets still nervous over putting money into companies that often are years away from generating revenue, trade sales have become a more favourable exit route, giving IP groups a cash return.
IP Group (IPO) is involved in several interesting business ideas including a 34.9% stake in private company Oxford Nanopore which is developing a new DNA sequencing method; and an 11.2% of Revolymer whose non-stick chewing gum could be a environmentally-friendly hit. At 44p, shares in IP Group are worth
a punt.
An alternative to IP commercialisation is Sagentia (SAG:AIM) which provides brand owners with new products, helps IP owners with business issues and scouts around for new technology to adapt into a product or service. Its Cambridge offices are a hive of mini-science labs with more than a passing resemblance to Q and his gadget creations in the James Bond films. Its activities range from making kettles and toasters more energy efficient to surgical robots and making Hornby trains produce steam from their engines. (DC)
BIOTECH: High Risk Medicine
Last December a group representing leading biotech companies presented the government with a dossier 'identifying the need for seismic change', which is to say they had the begging bowl out for government aid. The group wanted £750 million of public money to sit alongside a matching amount from the private sector to set up three new funds. The biotech industry has thus aligned itself alongside the car industry in seeking state support, which is probably as big a hint you will get as to its general investment potential.
The business plan of most biotechs is simple. They raise money in an initial public offering (IPO) to see them through three or so years in order to develop drugs which will take five years to bring to market, going through three sets of clinical trials. According to a study by the Centre for Medicines Research in 2004 for the worst group of drugs, those aimed at the central nervous system, the probability of getting through were statistically akin to zero.
Alizyme (AZM) provides an illustration of the dangers of investment in the sector. In its results published in late March the firm said cash and equivalents had fallen to £2.2 million as of the end of December, against which broker FinnCap estimates its cash burn at £4 million to £5 million per annum. The shares which were quoted over 160p three years ago can are now trading at 8p.
On a more positive note biotech is cheap. One reason the industry has gone cap in hand to the government is the difficulty of raising new money, but perhaps the main beneficiaries will be the big pharmaceutical firms which can scoop them up at a potentially knockdown price. In the meantime private investors are generally better off looking at players further up the evolutionary chain, such as Vectura (VEC), which can demonstrate revenues and have drugs in the later stages of development. The rewards of success may be less, but they are still high risk plays. (IM)
TECHNOLOGY: Geek Power
The technology and software arenas offer potentially rich pickings as the market is littered with lots of inventors all seeking to design the next iPod - or at least one of its central components. Some tiddlers are focusing on niches of already successful markets, such as Synchronica (SYNC:AIM), whose software enables any old mobile phone to be used for email in emerging markets where PC penetration is low. Vyke Communications (VYKE:AIM) is looking to tap into the voice over internet protocol (VoIP) market, enabling users to call abroad from their mobiles at a fraction of the cost.
Having reported its first pre-tax profit this year, IQE (IQE:AIM) is the leading global supplier of compound wafers for the semiconductor industry. Nudging into a market dominated by chips made of pure silicon, IQE's wafers are made from complex compounds such as Gallium Arsenide (GaAs) which are more efficient and there is significant potential for expanding their usage into areas such as solar power. One of IQE's customers is Enfis (ENF:AIM), which makes energy-efficient LED (intelligent high power light emitting diode) lights. These are potentially the light bulbs of the future as traditional incandescent lights are banned. But as with all growth that depends on regulation this could take longer than expected – as illustrated by the woes of Ultrasis' (ULT:AIM) computerised therapy software which remains at the mercy of decision-makers at the NHS.
OMG (OMG:AIM) has a leading position providing motion capture software for the movies, responsible for among others Tolkien's Gollum in the wildly successful Lord of the Rings trilogy. Keen to exploit in-house talent, the company has a incubator unit and has a record of successfully nurturing new technology units. Advanced Computer Software (ASW:AIM) wants to further industry consolidation after having taken on board Adastra, and agreed to buy Business Systems Group (BSG:AIM). Healthcare software is a promising space for Advanced Computer to focus on, as long as investors keep an eye out for growth that is organic as well as acquisition-driven. (JF)
Blinkx (BLNX:AIM)
Market cap: £52.8 million
Share price: 19p
Online video group Blinkx is making encouraging progress in its efforts to monetise the growing trend of watching of video over the internet, as its software enables advertising to be tied to relevant videos. Others have been less successful at this, with Vividas having to call in administrators last November. The not yet profitable Blinkx, which was spun out of Autonomy two years ago, was able to increase its rates last year in spite of a falling advertising market. Results are due this week. (JF)
Lombard Medical (LMT:AIM)
Market cap: £22.2 million
Share price: 2.8p
The January fund-raising secured the future of healthcare equipment maker Lombard Medical Technologies for the rest of this year. Its main product is the Aorfix stent graft for abdominal aortic aneurysms, which is more flexible and secure than existing products. With financing in place, clinical trials are now making good progress on recruitment. This could serve as a big selling point to partners looking to market Aorfix, or buy the not yet profitable company. (IM)
Ceres Power (CWR:AIM)
Market cap: £83.4 million
Share price: 127.2p
Profitability in 2011 is within reach for Ceres, as Centrica has taken the fuel cell company under its wing. Together they will bring combined heat and power (CHP) units, which equate to environmentally friendly boilers, to the masses. Ceres, which has £24.4 million in cash, also recently secured a £2.5 million deal with Calor Gas to develop a LPG (liquefied petroleum gas) version of the boiler. (JF)
Antisoma (ASM)
Market cap: £177 million
Share price: 28p
Oncology specialist Antisoma has two lead drugs: ASA404, which disrupts the blood supply to tumors, and AS1413, a leukemia treatment in phase III trials. Its market cap puts it at the large end of the biotech scale and it has sufficient cash to see it through to the middle of next year. The sale of its rights to non-core product fludarabine will give it ammunition for a further year. The successful closure of the sale, which could come next month, should give the shares a lift. (IM)
Imaginatik (IMTK:AIM)
Market cap: £6.3 million
Share price: 4.75p
Imaginatik's collaborative innovation software enables businesses to tap into talent and ideas that otherwise would have been missed. The method both improves processes and saves money for clients, which include a string of international blue-chips. Existing clients reported £170 million in cost reductions over the past two years. This year has seen a string of contract wins across sectors for Imaginatik, and house broker WH Ireland expects 2009 to be the year of maiden profits. (JF)
Imperial Innovations (IVO:AIM)
Market cap: £196 million
Share price: 340p
IP incubator Imperial Innovations which did well from its 23.7% stake in medical obesity treatment specialist Thiakis, which sold for nearly £100 million last December. Imperial got £2.9 million upfront, with potential £13.2 million further revenue if Thiakis meets certain milestones, and more from royalties if the product gets to market. There could be more of these exit deals to boost the share price, including 18.9% stake in Polytherics whose precision chemistry technology could eventually serve a biopharmaceutical market worth $63 billion, claims Imperial. (DC)
Vyke Communications (VYKE:AIM)
Market cap: £15.4 million
Share price: 24.5p
Affordable international calls from your mobile phone is Vyke's offering, as the group's mobile VoIP (voice over internet protocol) product can save users between 60-90% off standard roaming charges. Last month saw the group, which has a link-up with Nokia, raise £3.06 million from the market, and a new distribution agreement was announced to further expansion in the Middle East and Africa. House broker Daniel Stewart expects to see EBITDA (earnings before interest, tax, depreciation and amortisation) turn positive this year. (JF)
Falkland Oil & Gas (FOGL:AIM)
Market cap: £78 million
Share price: 88p
Of all the firms operating in the Falkland Islands this seems the most credible candidate to drill in the near future thanks to its farm-out agreement with the oil subsidiary of mining giant BHP Billiton (BLT). The latter has committed to drill two wells by the end of next year and, and while Falkland may need to bring in another partner to fund its share of the drilling the equation in this frontier area is fairly simple – either it finds vast quantities of oil and the shares rocket, or drilling is unsuccessful and Falkland hits a dead end. (TS)
Synchronica (SYNC:AIM)
Market cap: £15.4 million
Share price: 4p
A string of contract wins underwrote a 61% increase in revenues at April's final results from the mobile email and synchronisation software group, which is now expected to report its first pre-tax profit in fiscal 2009. More revenue has already been booked in the first quarter than in the whole first half of 2008.
An agreement with Nokia Siemens Networks ensures a scaleable delivery channel for the group, which currently focuses only on emerging markets where PC sales are low but mobile phone uptake remains brisk. (JF)
PureCircle (PURE:AIM)
Market cap: £336 million
Share price: 225p
A first-mover advantage should benefit PureCircle, which produces the natural high intensity food sweetener 'Reb-A' from stevia plants. Approvals from food regulators are coming along nicely, with the USA already on board and the EU pending. Coca-Cola and Cargill are among customers which have already launched products incorporating the calorie-free, non-chemical sweetener. House broker Hanson Westhouse estimates a 150% sales growth in fiscal 2009-10. (JM)
