Endowment Effect and AIM stocks

Funds full of AIM stocks have at times delighted investors. Their time in the sun is usually when credit eases and the economy picks up. From the lows of 2003, the AIM Index more than doubled in just three years. And, after the end of the last bear market in March 2009, the sector repeated this performance in less than two years. Yet, each recovery failed to match previous highs, and the sector is now down 30% from its 2011 peak. Recent performance has been twice as bad as the FTSE Smaller Companies Index, suggesting some specific AIM problems. Behavioural finance points to what might lie ahead for the troubled market, as emotion gives way to reason.

The key issue is funding, as credit tightens. The adverse impact on the economy of bank de-leveraging is now clear. Despite pressure from politicians to lend, banks need to improve their own capital adequacy, and have every incentive to call in loans from smaller companies. It seems that this retrenchment is impacting listed companies, too. And, equity fundraising is far from the heady days of 2009 when institutions flocked to support rights issues.

This is a hostile environment for any business that needs money. Unfortunately, many AIM businesses are still at an early stage of development, and have assumed that funding would come along if sales or other growth targets were met. The decision by Nautical Petroleum to sell out before it has completed its exploration and development, points to the frustration that some companies now feel. Indeed, good AIM businesses may attract bids from better financed rivals. But this may not be enough to bail-out portfolios with lots of these stocks.

One major constituent of the AIM Index, is mining. Gold miners have confounded investors as the gap between share price performance and the metal itself widens. Miners talk glibly about mining cash costs, but these estimates rarely include all the cash involved. Project start-up costs, financing costs, aborted projects and the real current cost of energy are rarely fully captured in these hypothetical cost estimates. The reality that many mines have marginal economics even at current gold prices is only evident when money runs out. Investors now have no appetite for injecting more money, unless revenue is imminent.

Many of the funds with exposure to AIM were star performers from early 2009, albeit with some fading in recent months. Yet, underlying liquidity in some of these stocks is rapidly draining away. Where are the marginal buyers for AIM shares? Screens show stock prices that are often meaningless. For some AIM shares, market prices point to levels at which dealing is not actually taking place. Where managers need to fund redemptions or share buy-backs, they will need to achieve effective price discovery, possibly at much lower levels. At some stage, forced selling seems likely. And, even without redemptions, the change in appointed managers for some funds is likely to lead to problem stocks being rooted out of portfolios. New managers have less emotional attachment to these businesses.

Viewed dispassionately, trying to stock-pick amongst AIM rather than mid cap no longer seems worth the risk. Over the past 18 months, mid cap has outperformed AIM by one-third. But the endowment effect suggests that attachment to stocks already owned is preventing holders from understanding what others might pay. These shares may not be worth what the holders think, or even what the screens show. Over the next few months, this gap will be resolved as holders of AIM stocks are forced to seek liquidity. But, it is the rational investors that are likely to win, and new buyers may pay much lower prices.