Stock picking and how to avoid another Sirius Minerals

Small companies with big ambitions can be hugely profitable for investors, but how do you spot the warning signs and give yourself the best chance of picking a winner. Award-winning AIM writer Andrew Hore has some great ideas.

Small companies with big ambitions are creditable, but it can be difficult to fulfil those ambitions, especially when significant amounts of cash need to be raised. It is easy to overestimate the ability to raise large sums of money, and many do. 

The most recent example is Sirius Minerals (LSE:SXX), whose shares crashed in spectacular fashion this week. The company is trying to raise the cash to develop its enormous polyhalite project in North Yorkshire. 

It had appeared to be progressing well, but Sirius has now suspended its $500 million bond offering because it does not believe it can raise the cash under current market conditions. That's down to additional demands by potential investors, which could not be met without a waiver from its revolving credit facility provider. The government has rejected a request to provide £1 billion of bond guarantees.

Sirius moved to the Main Market in 2017, but much of its progress and share price improvement happened when it was on AIM. The pace of development will slow even though Sirius has £180 million pounds in the bank.

House broker Shore Capital is putting a brave face on it, and the preferred scenario would be to issue shares to raise the money for the vertical shaft. This could involve a strategic investor, and this would then make it easier to raise $250 million in project debt to finance the transport tunnel. 

The vertical shafts will cost $500 million and a look at the share price graph will show how dilutive this level of fundraising would be after the share price fall. 

The value of the underlying project is unlikely to change, but the increased number of shares mean that the value per share will be much lower and the upside for the share price would be severely limited.

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This highlights the problem with small companies trying to bring a large mining project into production. A larger miner would have better access to capital, which is why some smaller mining companies sell on the project during its development, or at least bring in a larger partner to put up a significant proportion of the funds required in return for a majority stake. 

It is all very well to have a mineral deposit, but there are real questions that will determine the project's ultimate success. Can the material be got out of the ground? Is it going to generate a profit? On top of that, can the management team deliver such a project?

Once a small mining company reaches the point when it has determined there is a commercially viable large project, it is unlikely to be a smooth ride if it is going ahead itself. That is the point when investors should consider whether it is time to sell.

Regulatory risk

AIM is littered by drug development companies with treatments that have progressed through trials only to run into problems at a late stage. 

Motif Bio (LSE:MTFB) is one example. It appeared that its iclaprim hospital superbug antibiotic was on the brink of being approved in the US. However, concerns about liver toxicity meant that further trials were ordered by the US Food & Drug Administration (FDA).

One of the important things to look at when a company is progressing the approval process for a drug is its financial position. Motif Bio's problem is that it has little in the way of cash and a poor share price. That makes it difficult to finance further trials without severely diluting existing shareholders.

Another example of this regulatory risk is the rise and fall of US-focused online gaming businesses more than a decade ago. These businesses were a market favourite until the boss of BetOnSports was arrested in the US in mid-July 2006.

David Carruthers was collared at Dallas-Fort Worth International Airport as he changed flights on his journey to the company's office in Costa Rica. The US courts passed a restraining order that prevented BetOnSports from taking bets in the US, which generated more than four-fifths of its business. Founder Gary Kaplan was accused of having links to the Mafia and illegal gambling in the US.

The knock-on effect was a slump in the share prices of rival online betting firms, even though some did not have any US business. The likes of Sportingbet, World Gaming, BetCorp and Leisure & Gaming, which the previous year had bought a business with 84% of its revenues in the US, lost around one-third of their value in a fortnight.

E-wallet provider Neteller also lost more than one-third of its value. Neteller had been growing rapidly and much of that growth was due to the e-wallet being used for online gaming in North America. 

The legality of online betting in the US was always questionable. There was no specific legislation relating to it, but there was an act in the works called the Internet Gambling Prohibition Enforcement Act, which had been passed by Congress, but it had not reached the Senate. There were some courts and attorneys that viewed the companies as disregarding existing laws. 

The attraction was the enormous potential market, and this appeared to override any sense of the real risks of becoming involved in a business where the legality was hazy to say the least. 

It appears that a similar thing could start to happen with companies involved in the cannabis sector. Investors are encouraged by the massive potential markets, but the exact legality of cannabis and variations of it are still not certain. They can also differ significantly from country to country. Some companies could fall foul of this in certain markets. 

The quoted companies involved in the cannabis sector tend to be very small and most appear likely to fall by the wayside. Picking a successful one is difficult at this stage and most will probably not amount to much in the end because they are speculative businesses.

Trying to change a market

When a company starts from scratch there is the whole market to go for. It does not mean that they will get much if any of that market.

Tungsten (LSE:TUNG) joined AIM saying it was going to monetise its e-invoicing network that processed more than £100 billion of transactions each year, which itself was a small percentage of the total market. It also acquired a bank to help with this strategy. The bank was sold less than three years later for £29.6 million - similar to the purchase price.

The market appears an impressive size but the revenues that can be generated are a tiny percentage of total transaction value. Generating significant revenues from the buyers and suppliers proved difficult. 

At 44p, the current share price is nearly double its low but nowhere near the flotation price of 225p six years ago, when £160 million was raised in a placing. The company was valued at £225 million and it is currently capitalised at around £56 million. Even before it floated, Tungsten's main business had invested £50 million in developing its operations.

The good thing about raising all that cash is that it funded the losses over the years, but there is little of it left. In the year to April 2019, revenues had reached £36 million, based on 18.2 million transactions, and Tungsten lost money. An operating profit has been indicated for the first quarter.

Others benefiting from investment

Just because a company has poured money into developing a product it does not mean that it and its shareholders will be the ones that benefit. A recent example is the purchase of water filtration IP from Halosource (LSE:HALO) by kettle and small domestic appliance components supplier Strix (LSE:KETL).

HaloSource had pumped millions of dollars into developing the products and IP and Strix acquired them for $1.3 million. It has already lined up a deal for a Philips brand product that will use the technology and there are more deals to come.

There are technologies, which never quite seem to take off after sky high expectations early in the company's quoted career. 

The London market is littered with examples of companies, which, even if they have made progress, never achieved the overoptimistic expectations of many advisers and investors. 

An extreme example is fuel cells developer AFC Energy (LSE:AFC). Back in April 2008, Blue Oar forecast that AFC would go from little or no revenues to revenues of £14.06 million in the year to October 2011. In fact, it only made £35,468 in 2011! They've been volatile over the years, but, adding up all revenue for the five years to October 2018, they come to well under £5 million, and the reported pre-tax loss is more than £28 million.

The moral there is be wary of forecasts, particularly if they expect impressive growth. The product has to be developed and ready if it is going to generate revenues. 

These types of companies regularly come back to the market asking for cash because, with a little more money, they can make that jump to more significant revenues and profit. But it rarely happens. Some, like Transense (LSE:TRT), which was initially focused on the new car market for its tyre pressure sensors, have to adapt their strategy to more niche markets that are nowhere near as large but could become the basis of a business.

Patience is required when it comes to developing technology. However, investors need to question the progress that is being made and whether injecting more cash will be worth it or it would be better to write-off the investment. 

Interactive TV technology developer Motion Television is a prime example of a company that kept on raising cash via share issues, yet never significantly grew revenues so it could reach a profit. The only thing that grew rapidly was the tax losses. Eventually, investors would not stump up any more cash and it went bust.

Even if it is a good technology it does not mean that it will succeed commercially. Inferior technology may have the ability to dominate the market.

Hype

It is also important not to get overexcited by brand names and individuals involved in a company. Fully listed Aston Martin Lagonda (LSE:AML) is an example of a flotation that attracted investor interest because of its brand name rather than its fundamentals and valuation.

Poptones floated on AIM on the back of being run by former Creation Records boss Alan McGee, who wanted to build up a new record company. That is not easy to do, and it takes more than one big selling LP – as it was in those days - or download. Poptones did not prosper in its limited time on AIM.

Neither did The People's Operator, backed by Wikipedia founder Jimmy Wales and boasting a board packed with blue-chip talent. The mobile virtual network operator (MVNO) - it sold pay monthly and pay-as-you-go mobile contracts – gave 10% of every customer's bill to good causes, but went bust in February, four-and-a-bit years after its IPO in 2014.

It is not a bad thing to be ambitious, but investors need to take a sensible view of the risks and the things that can go wrong with a strategy. Any changes to strategy will undoubtedly affect the value of shareholders' investments. 

In reality, these examples show that investors must be aware of the risk and, just as importantly, the hype behind a business. They need to consider what will happen if the business or project does not progress as expected. Only when you accept such high risk should you take the plunge.   

Andrew Hore is a freelance contributor and not a direct employee of interactive investor.