Why UK AIM stocks are taking a battering

There is no doubt that AIM Stocks have suffered recently. In early summer, the expectation was that inflation had been tamed and the interest rate cycle had turned. This led to some optimism returning to the market, which had been beaten down for so long. Here is what the AIM100 index looks like over three years:

However, that optimism has proven short-lived. The surprise election in July led to an increased focus on what an incoming government would look like and what impact this would have on investors:

The effect on the smallest UK stocks from this uncertainty has been two-pronged. Firstly, it appears to have caused a dip in consumer sentiment. The GfK Consumer Confidence index dropped to -20 in September from -13 the previous month. Expectations for personal finances over the next 12 months, the 12-month outlook for the economy and the major purchase index all fell significantly. The blame has been put on worries about what will be in the Autumn Budget that will be announced on 30^th October. The message from the new government has been that public finances are in dire straits. The view is that the lack of investment in recent years needs to be corrected, and this needs to be funded by tax rises rather than borrowing.

We've seen the impact of this reduced consumer confidence already, with many smaller UK companies warning of challenging market conditions and a number of profit warnings recently. Even companies that haven't warned are saying they expect to be very H2-weighted. In many cases, the market is calling this hope misplaced and marking the shares down anyway.

The second impact is that investors have been getting ahead of what they see as the most likely tax changes. The two that seem to be the most talked about are changes to capital gains tax or the removal of inheritance tax relief on AIM shares. In addition, there may be changes to ISA or SIPP rules and how Oil & Gas profits are taxed.

Capital Gains Tax

The principle of Capital Gains Tax is that any gains made in a tax year above a threshold and outside of tax shelters such as a SIPP or ISA are subject to a tax rate, but investors can offset any losses (outside of tax shelters) against those gains. The previous government had already reduced the threshold above which tax is due:

However, the tax rate remains favourable compared to income tax, at 10% for Basic Rate taxpayers and 20% for Higher Rate taxpayers. Investors will not welcome any move to bring these more in line with income tax. However, these won't necessarily cause investors to realise gains and add to the selling pressure on stocks now, as any tax rate changes will likely come in the new tax year in April at the earliest. This change is unlikely to unduly impact small stocks as sales would likely be uniform across all companies.

ISAs & SIPPs

Various possibilities are under consideration, including limiting the tax-free gains in ISAs or reducing the tax-free amount available from SIPPs upon retirement. The other SIPP change some are proposing is to limit higher rate tax relief on pension contributions. While all of these may impact individual investors, they are more likely to limit flows into equities in the future rather than cause outflows now.

AIM IHT Relief

A quirk in UK tax law makes AIM shares held for more than two years exempt from inheritance tax. They are treated the same as unlisted companies, and the will's executors can claim Business Property Relief (BPR) on these holdings. This is the case even if they are held in an ISA, which makes this a particularly good deal for investors and one that many take advantage of in their later years.

The strength of this tax break has also made it a popular one; some estimates put upwards of 30% of money invested in AIM shares for this reason. Unfortunately, the popularity of this strategy also makes it ripe for a change in legislation. The original idea behind BPR is that it allows family-run companies to be passed on to the next generation without having to be broken up or sold to pay death duties. This encourages entrepreneurship and individuals to take equity risk and drive economic growth, which will fund corporation tax payments and payroll taxes over the long term. Although not all AIM companies fall into this category, the idea of supporting smaller companies with growth capital kept this relief in place for AIM shares. However, investors in AIM stocks purely for IHT purposes often do not want to take the risk associated with growing smaller companies. Indeed, they often try to have a highly diversified portfolio in the most boring dividend-paying stocks which are unlikely to need fresh equity. Their primary aim is not to lose money rather than generate market-beating returns. This mismatch is why a change of legislation may make sense to an incoming government.

The popularity of this strategy also makes it attractive for change. It seems to be this fear that is specifically impacting AIM stocks. The following chart clearly shows the divergence between the AIM100 index and the FTSE SmallCap Index since the election as called:

Of course, no one will be selling AIM stocks for this reason today since that would immediately nullify the tax break they fear will be removed in the future. However, the possibility of this change may have stopped investors from investing fresh capital into AIM stocks. Given that there is a natural flow of money out of these stocks as AIM IHT investors die and their descendants reposition themselves into assets that more closely fit their financial situation, this may explain some of the AIM weakness we are currently seeing.

The other big cause of the sell-off is investors anticipating this change and the flow of capital out of this part of the market. Many don't want to run the risk of owning anything that could be exposed to this. It is certainly possible that the immediate removal of BPR would cause a 30%+ crash in the value of the type of stocks that AIM IHT funds prefer.

Will these changes happen?

Many of these changes are rooted in sensible adjustments to the tax code. The problem is that the secondary effects will likely overwhelm any real tax gains. Changes to the Capital Gains Tax would likely encourage the emigration of the most asset-rich. The changes to ISAs and SIPPs mooted would add significant complexity. Removing BPR from AIM stocks would immediately reduce Capital Gains Tax receipts as many of the losses would be tax deductible, and it would be some years before the Inheritance Tax increase came through. However, investors should be wary about assuming that this logic will stop these changes from happening. This government has already shown it is prepared to put idealogy above economics when it comes to North Sea gas production, for example.

The reality is that significant changes are likely to happen with a sufficient lag for investors to take action on any legislative changes. However, this won't stop the secondary effects we have seen already impacting AIM stocks. On the plus side, if these changes don't happen, expect cash that has been sitting on the sidelines into stocks that now appear very cheap by historical standards.

Are commodity stocks safe?

One of the aspects of BPR that investors need to consider is that certain types of stocks are excluded. These come from the original aim of the 1976 Act, which was to allow family-owned trading businesses to be passed on without Inheritance Tax. In order to do this but not provide an obvious tax avoidance measure, the legislation needed to prevent incorporating non-trading assets for this purpose. Hence, the following types of stocks are excluded from BPR:

– those mainly investing in shares;

– those mainly investing in property assets;

– those dual listed on a recognised foreign stock exchange.

HMRC does not publish a list of BPR-qualifying companies. Entitlement is assessed once a claim for relief is made. This lack of clarity means that investment managers for IHT funds are conservative and invest in companies where they are certain relief can be claimed. AIM-listed housebuilders may be considered as investing in property assets due to their land banks, and resource companies can be viewed as owning property on any non-producing assets. IHT funds simply avoid these sectors rather than risk an adverse HMRC ruling after BPR relief is claimed.

So, in a turn-up for the books, the small cap resources companies on AIM may be some of the safest stocks in the short term. They are unlikely to have attracted IHT fund flows, making them immune from this effect. However, some resources companies face a tax challenge of their own - higher taxes on North Sea Oil & Gas production. It is this that has made Serica Energy (LON:SQZ) one of the worst-performing larger stocks on AIM this year:

The big risk here is not the expanded Energy Profits Levy but any changes to the treatment of capital allowances. Currently, companies can reduce their near-term tax bill significantly through large capital expenditure. Something Serica has been taking advantage of, perhaps to get ahead of the possibility of changes in this area. However, in their last presentation, Serica estimated that they would generate their current market cap in cash in four years, even under the most pessimistic assumptions for tax changes. So it is possible that there has been an over-reaction by the market within this sector.

Which stocks are at risk?

The easiest way to find out the type of stocks most at risk is to look at the IHT funds. The longest-running and largest is the Octopus AIM IHT fund. This has £1.5b under management, so it is certainly not insignificant in its scale or impact on the market. Unfortunately, they don't publish their holdings, and Octopus have a total AUM of over £13b, so we can't use holdings announcements alone to work this out. However, we do know that they aim to hold 20-30 holdings, and these have an average market cap of around £600m. This scale severely limits their choice of stocks. A quick screen for AIM100 stocks with a market cap of >£300m and not dual-listed/resources/housebuilders produces just 48 stocks. I wouldn't be surprised if the Octopus AIM IHT fund owned at least half of these names. Take RWS Holdings (LON:RWS) as an example. It is likely that the majority, if not all, of Octopus's 5% stake here is in the AIM IHT fund:

The RWS Holdings (LON:RWS) share price weakness this year may be as much down to the fear of BPR removal as worries about the impact of AI on the company's business model:

Some other IHT funds are more open. For example, the Downing AIM Estate Planning Service ISA is much smaller, with AUM in the £130m range, but it has quarterly factsheets giving details of its holdings. Here is June's:

In the latest two factsheet commentaries, they also mention Flowtech Fluidpower (LON:FLO) Loungers (LON:LGRS) 1Spatial (LON:SPA) James Latham (LON:LTHM) Inspecs (LON:SPEC) Tracsis (LON:TRCS) Marlowe (LON:MRL) Frenkel Topping (LON:FEN) Eagle Eye Solutions (LON:EYE) Frp Advisory (LON:FRP) H & T (LON:HAT) Gateley (Holdings) (LON:GTLY) and Sigmaroc (LON:SRC) . Despite a claimed value bias, the Value Rank is not particularly high for many holdings. Few of these stocks are SuperStocks, and there are a number of High Flyers and Falling Stars in there, perhaps reflecting that stocks have to be held for two years to get BPR; hence the turnover is low even when the value may have outed.

Many of these stocks look at the risk of large falls if BRP is removed from AIM shares.

The other well-known IHT fund is the Puma AIM IHT ISA, with around £230m AUM. Again, they don't give a breakdown of holdings but simply say they invest in:

A diversified portfolio of larger AIM companies. The Puma AIM IHT Service intends to invest only in quality companies that are considered to be profitable and cash-generative.

Here is the breakdown of the portfolio by the market cap of the constituent:

The only company they specifically mention in their brochure is Tracsis (LON:TRCS) , but I think it is safe to say they own very similar companies to Octopus, along with some of the smaller companies that Downing owns. It is this concentration in the same stocks across all managers that adds to the risk for these types of companies.

What should investors do about this?

Benjamin Graham famously said:

In the short run, the market is a voting machine but in the long run, it is a weighing machine.

Graham loved it when the market's voting got out of step with the weight of a business since this gave a favourable risk-reward ratio. If these changes in tax and all the associated impacts happen, they will certainly change the short-term voting of the market. However, the weight of these companies will not be changed by this. After all, a company is worth the net present value of cash flows returned to shareholders via dividends or capital returns in the future. Therefore, long-term investors may want to simply sit tight and ride it out, aware that nothing fundamental has changed in the companies they have invested in.

Indeed, if changes to BPR are implemented for AIM stocks, it could be a once-in-a-generation opportunity to pick up quality assets at a significant discount to their intrinsic value. At least for those who have cash on the sidelines or a regular income.

More cautious investors may want to minimise their exposure to the stocks held by IHT funds. However, the problem is they may already be behind the curve and be selling stocks where the market has already priced for a worst-case scenario. If the change to BPR doesn't happen, then capital will likely flow back into AIM rapidly. They will have sold low and bought high. One way may be to consider selling the AIM stocks that have bucked the trend and risen over the last few months, particularly if they don't look cheap. Here are some of the AIM stocks that likely qualify for BPR sorted by their 6m relative strength:

Some of these are special situations. However, many of these look like they could face a severe correction if BPR is removed. For example, as good as James Latham is, and despite being a SuperStock, it is exactly the sort of company that many IHT funds will own and is surprisingly illiquid for its size. There is little sign that the increased risk has been priced into the stock:

Another factor that investors may want to consider is how the companies themselves will react to significant falls in their share price. In this environment, I prefer any AIM stocks I own to be cheap, have net cash, pay large dividends, and either buy back shares or have the capacity to do so. A high dividend yield will likely act to limit the downside from any sell-off. Companies that are able to take advantage of any falls in the share price to buy back their own shares at bargain prices will generate above-average returns over the long term, whatever the short-term outlook. This will not mitigate the short-term pain of any drop, but it will lay the foundation for a more rapid future recovery.

[Disclosure: Mark owns shares in Ramsdens Holdings (LON:RFX) RWS Holdings (LON:RWS) ]