Why are people chasing these stocks?

On Wednesday, I said that the FTSE 100 isn’t bad value – at least not compared to houses! Trading at 12 times earnings, the FTSE 100 is actually lower than its historic average. And I wasn’t surprised to see the index blast through 6,200.

I mean, there’s a lot of new money appearing on the scene. Many investors have grown tired of sitting on the sidelines. And they probably like the look of the relatively decent 3.5% return they are getting in income from the FTSE big boys.

But it’s true that many of the large cap stocks look a bit long in the tooth. The nimbler FTSE 250, which includes many smaller companies, has actually performed much better than the elders. But if you want a slice of that action, it’s gonna cost you. 19 times earnings is what you’ll pay. The yield on the faster moving 250 falls to 2.7%.

Still, that hasn’t stopped investors from pilling into these small stocks. And as I’ll explain today, that is becoming a very dangerous game indeed…

This is dangerous ground

The FTSE Small Cap index is the next rung down the ladder from the FTSE 250. It’s the next 250 stocks. We’ve already seen that as you head down the league table, you pay more for your stocks. But I think this might shock you: they’re trading on an average 45 times earnings! To put that in context, it means that on today’s figures, you’ll have to wait 45 years for your investment to earn back the money you put in!

And if you travel as low as the FTSE AIM market, you’ll find that, taken as a whole, there are no earnings at all! The guys that organise the index therefore can’t even give us a price/earnings (p/e) ratio.

I accept that there’s a whole gamut of stocks floating around in the small-cap universe – some undoubtedly with great merit. But there’s a hell of a lot of trash. Without earnings, much of them are more like gambles than investments. And they are expensive gambles at that.

If you invest here, I think you stand a very good chance of losing money. In my experience, the small-cap market is a dangerous hunting ground.

That doesn’t stop private investors from taking a big interest in these stocks however. Yesterday I was on the train and stuck for a few minutes. I found myself clicking on the link for the most accessed threads on a popular investor’s bulletin board.

It turns out that of the nine most popular stock threads, eight were small-cap resource stocks (miners and oil explorers) – the only biggie was Vodafone. I was quite shocked by that.

The point is that these little stocks generate a fantastic amount of noise. They take up a lot of investors’ time, and moreover, they lose investors a lot of money.

Just look at the charts of today’s three most hotly debated stocks and I think you’ll agree. These are not the sorts of things you want to fill your portfolio with….

Hot stock 1: Gold Oil

Gold Oil share price chart

Hot stock 2: Gulf Keystone

Gulf Keystone share price chart

Hot stock 3: Xcite Energy

Xcite Energy share price chart

Given that many private investors probably get suckered in on the wild up moves, it’s clear that there have been great losses on the majority of these stocks.

To be honest, I think many of these stocks will probably end up in the knacker’s yard. Maybe I’m just being cynical. But the way I see it, a lot of this stuff has been floated to an unsuspecting public in a bid to make the backers rich.

I’m talking about the accountants, lawyers, banks and so-called ‘entrepreneurs’ that help bring these stocks to market. And getting this stuff to market requires a fantastic story – and quite literally, much of the small-cap resources sector is fantasy – much of it written by a clever City PR firm.

So, while it might be fun – I’m certainly not above a punt or two – I worry about the amount of attention these stocks get among private investors. Especially now…

Out of the frying pan and into the fire

2013 saw the dawn of a new era for the finance industry. The Retail Distribution Review (RDR) sees commission on financial advice kicked into touch. Fantastic! You can read all about what it means for you here.

But there is a sting in the tail…

I suspect that many private investors will be loathe to pay advisers for counsel on how to invest their hard-earned cash. Many will plough their own furrow. And in many cases, it’ll cost them dearly. I know – I’ve been doing this stuff since I was a teenager. And believe me, I’ve made all the mistakes you can make!

I can see many small investors wasting fruitless hours chasing the ‘fascinating’ stories of small-cap resource stocks. And this is not good enough!

I am proud to say that MoneyWeek campaigned incessantly for fair treatment on investment commissions. And now that it looks like we’ve got it, I think it’s time to move the battle lines forward.

We need to look at the mess that constitutes the dark side of the stock market. That is, the small caps and AIM markets. AIM in particular needs to take a good, hard look at itself. Companies floated purely to make money for the industry and somehow provide investor entertainment is clearly wrong.

While we stoke up the debate on that, may I offer some advice…

Beware the fantastic stories that do the rounds on investor forums. Bulletin boards can be a great place to find out information on stocks. But the best way to look at them is usually as a contrarian indicator. The greater the story, the greater the noise and razzamatazz… the greater the fall.

So if you are tempted by this side of the market – then for heaven’s sake, buy the stock when it’s trading near its lows. These sort of stocks can offer marvellous potential. But only if you get your timing right!

So do your own homework and do it diligently. Only invest in companies that have decent cash backing, as a company coming back to the market for more money will trounce your investment.

• This article is taken from the free investment email The Right side. Sign up to The Right Side here.

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17 Responses

  1. 25/01/2013, fly fly wrote

    The figures I’m seeing (Bloomberg) have the UKX on a PE of 15.9x 2012 earnings or 11.59 times 2013 estimates. MCX it has on 20.9x 2012 earnings and 13.8x 2013. If that’s accurate, and you may well have better data, then I’d rather have the mid caps.

  2. 25/01/2013, James wrote

    Hi Bengt,
    It’s an interesting article but didn’t you recommend Agriterra AGTA:LN back in December which is also a small cap, no earnings company. Do you still stand by your recommendation in spite of your article?

  3. 25/01/2013, Jon wrote

    I got caught out by Xcite but made 400% on Cove! AIM is for your horse racing money not investment money. A few quid on AGTA and Zambeef, there are more millionaires in Africa than India!

  4. 25/01/2013, Steve T wrote

    So what the small cap index trades at 45 times earnings?

    It’s all about stock picking and ignoring the noise. I probably wouldn’t invest on Gold Oil or Gulf Keystone but Xcite Energy – that’s a different story. It has 100% control over a large proven oil field (Bentley) in a safe (non-nationalisation) North Sea. The pre-production well test was successful in September 2012, with initial well test results exceeding expectations. In summary it is sitting on massive proven assets (2P reserves of 116 million barrels of oil equivalent for the core area of the Bentley field, never mind the rest of the field) and is now sensibly seeking a farm-in partner to bring it on stream.

    I suppose you had the same doom and gloom message about avoiding Nautical Petroleum in 2007 when it was 8p but no doubt revised your opinion when it was bought out at 450p in 2012? BP, assuming it survives as an independent company, isn’t going to match that 56 bagger is it?

  5. 25/01/2013, Michael wrote

    Bengt I think you misunderstand what AIM investors are about. Jon makes the point well. The noisiest BB of them all must be LSE’s Scancell Board. And for good reason, it was the top performer of 2012 as you surely remember? I bought in at 8p, I have learnt a lot, because what they’re doing is fascinating, and it’s an investment in a company that might actually make a difference…PS You’re right about buy-to-let though.

  6. 25/01/2013, Mac wrote

    YOU R RIGHT, Listened to someone on the Motley Fool, Lost 80%.
    Never listen to anyone on Small cap.

  7. 27/01/2013, Baxter Basics wrote

    So, I take it you’re not a big fan of Tom Bulford’s “Red Hot Penny Shares”, then?

  8. 27/01/2013, Baxter Basics wrote

    BTW I agree strongly with what you’re saying, mind.

  9. 28/01/2013, Kel wrote

    fly fly, may I ask where on the Bloomberg website you were able to find the P/E ratios? I can’t seem to see them on the UKX or MCX pages or charts. Thanks very much.

  10. 28/01/2013, Old Buffer. wrote

    Tom Bulford and Avanti Communications,anyone?
    Hyped to almost hysterical levels by Bulford in one of his videos!

  11. 28/01/2013, r wrote

    Tom Bulford and Vatukoula Gold, anyone else? Tipped at about £2.00 and now 25p.

    I never did invest much in the RHPS tips and gave up with it altogether when they stopped posting it and then prevented you from printing it online.

    I have done a lot better with my own research after reading view from MW, for example.

    r.

  12. 28/01/2013, jimtaylor wrote

    I agree with the comments 3, 4 & 5 above – a lot of fun and interest can be had by using a small part of a portfolio trying to put some icing on the cake without risking the cake!

    I’m currently having some fun with SDY, PFD, LONR and FJET.

  13. 28/01/2013, mark wrote

    The problem with lots of AIM stocks (those with no earnings anyway) is the seemingly constant dilution which often takes place at big discounts to sp, decimating shareholder value in the process. Despite this, a fair proportion of my portfolio is in AIM stocks, either in cheap resource stocks (that don’t require new equity funding at regular intervals) or companies with potentially disruptive technology addressing multi $b markets (e.g. AFC, OCG)

    There are a lot of small miners on AIM but along with the trash there are some very profitable juniors trading below book value and on very low PE’s – HGM, AAZ and OMI for starters….

  14. 28/01/2013, Impromptu wrote

    Call me an old fuddy-duddy but I don’t regard bagger-or-bust investing as “fun”. I’d rather a 60% chance of a 4% gain than vice versa, and even “horse racing money” is still money. Still, I suppose if you are prone to such impulses it’s useful to satiate them with a few punts here and there, so the mentality doesn’t creep into your more sober investing.

  15. 28/01/2013, Iain wrote

    Suprised to hear you knocking GKP and XEL without first researching the companies. I have made many £1’000 on both of these shares and could never get the same return on ftse 100 shares. You shouldn’t knock companies without checking them out 1st. Would love to hear what your warnings are regarding XEL in particular as I cant find nay??

  16. 30/01/2013, SteveT wrote

    Agriterra is an aim stock

  17. 05/02/2013, the burnt investor wrote

    Thats one of the most sensible articles i have read in a long time.New investors in particular should note this advice lest they join the disillusioned after their hard earned cash has been frittered away on “pipe dream ” shares

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