Since its launch in 1995, the Ofex market has made significant progress. As of January 2001, over £9...
Since its launch in 1995, the Ofex market has made significant progress. As of January 2001, over £900m has been raised by constituent companies. Some 49 companies have progressed from Ofex to more senior markets a migration pattern that has increased by over 100% in each year since 1997. The overall capitalisation of the Ofex market has grown at an annualised rate of 13% since 1997, and it currently has in excess of 200 companies with a combined value of £2.4bn.
The success of Ofex reflects a balancing of objectives between entrepreneurs and risk-minded investors. Founders of early-stage businesses requiring substantial capital for growth are often concerned about premature dilution of their ownership. A listing on Ofex can provide access to funding that may be on more attractive terms than alternative sources, plus the ability to incentivise staff through marketable shareholdings. A higher public profile may be another reason to go for a listing, rather than using venture capital. Investors, for their part, have an opportunity to make sizeable gains.
In 1998, National Car Parks was the subject of a £800m bid by Cendant Corp, when its Ofex market capitalisation was £685m. Similarly, Turbo Genset progressed from Ofex to a main listing in 2000, at a valuation of £860m.
In line with stock markets generally, Ofex activity has softened in 2001 compared to the heady days of a year ago. Trading volumes are well down on the comparable months of 2000, but are nevertheless substantially higher than those of early 1999. Fund raisings are also well down but, in contrast to the technology-led boom of early 2000, company valuations are more realistic and a wider spread of businesses are now being represented. A wider investor audience is also now involved. As well as the mainstay private and business angel investors who have been long term supporters of Ofex, the market is seeing increasing activity from institutionally based funds and private client stockbrokers.
Scottish Value Management's Ofex Fund is one such institutional fund, and, thus far, it is the only one to be focused exclusively on this market. It was launched in October 2000, although SVM has been investing in Ofex, and similar early-stage companies, through its other funds for several years. SVM's overall investment approach emphasises small and medium sized companies. Not because it intrinsically likes such companies, but because it looks to pick those that will hopefully become very much larger. It seeks to identify under-researched companies that have a sustainable business model likely to produce long term earnings growth.
The Ofex market offers a potentially rich source for this type of company. Key business attributes include a scaleable opportunity, likely to drive rapid turnover and profit growth. This will probably involve dominance of a particular market niche, or agreements with established trade partners to accelerate market penetration. Where new technologies are concerned, it should include some proof of concept in terms of achieved sales, or at the very least, verifiable sales prospects.
The Ofex investment opportunity comes from exposure to companies that have the potential to progress to more senior markets. SVM is looking for scaleable businesses that are unlikely to remain on Ofex. Their growth prospects should make them capable of achieving an AIM or main market listing within a reasonable timescale. Appetite from a wider institutional audience can act as a dramatic driver to share price performance. The fund has the capability to retain investments once they leave Ofex for a period of up to a year. It can also invest in private companies that are well advanced in their plans to list on Ofex or more senior markets.
As there is currently no official Ofex index, the benchmark for the fund is the FTSE Fledgling Index. This has outperformed the FTSE All Share Index by more than 70% over the last two years, reflecting widespread investor interest in smaller growth companies. The Fledgling Index is a larger universe than Ofex, currently comprising 653 companies with a combined capitalisation of £16bn. These companies rank below the cut-off level for the All Share Index, with the biggest being a £138m investment trust. This reflects the overall makeup of the Fledgling Index which is dominated by investment companies. These account for nearly 30% of the total, with almost 40% in financials generally. Services is the next largest segment at 23%, covering consumer and business services companies.
The financials component in the Ofex market is much smaller, representing only 12% of the total number of companies. It has, however, a much greater exposure to services which represent over 40%. In this respect, Ofex is much more indicative of the changing nature of growth within the UK economy.
The large number of service companies on Ofex reflects the decline in the importance of traditional manufacturing and processing. Emergent companies are now predominantly service-based, in many cases exploiting the fast growth in outsourcing activities being driven by the need for corporate efficiency. This trend propelled a company such as Capita from obscurity into the FTSE 100. With strong cashflow and relatively low fixed capital requirements, these companies can grow at much faster rates than more traditional businesses, and investors can generate significant returns by identifying them at an early stage.
The SVM Ofex Fund will focus on these high-growth segments of the UK economy. In particular, its portfolio will feature areas such as technology, which increasingly overlap with business services through the outsourcing of IT requirements.
It will also take exposure to healthcare, where growth is being driven by a combination of new biotechnologies, legislation and Government spending. However, industrial related growth can be still found in new production processes that have a patentable edge, and selective investments will be made where there is a mass market application.
In general, the fund will avoid businesses that suffer low barriers to entry, or limited pricing power. This need not always be in mature 'old economy' markets, as the failure of so many dot.com-related businesses has shown. It will also concentrate on business models offering strong organic growth prospects. Acquisition-led strategies that require regular funding from investors tend not to offer the same attractions.
Risk will always be present in any early stage investment and setbacks are almost inevitable. Any investor looking at an Ofex business proposal should be armed with a healthy degree of cynicism. Development plans generally take longer and cost more than company projections indicate, so a contingency element must always be factored into turnover and profit forecasts.
The company valuation must still look reasonable after such adjustments. Early sales generation is the lifeblood of an emergent business, but forecasts must reflect realistic expectations about volumes, unit prices and market penetration. Where possible, due diligence comfort can be taken from the involvement of established trading partners.
Capital markets providing early stage funding have been ever-present in the UK, with previous incarnations of Ofex including the Unlisted Securities Market and the Rule 535 (2) Over The Counter market.
The funding need will always remain since small and medium sized enterprises represent the vast majority of corporates in the UK. For those prepared to invest in Ofex, the rewards can be considerable.
David Stevenson is a fund manager at Scottish Value Management
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