Everyone loves the idea of a blue-sky punt. It is an investor’s dream to pick up a tiny stock for pennies, maybe a loss-making company beavering away with a brilliant idea, and then watch as its ideas and products catch on, start-up losses turn into huge profits and the stock rises tenfold or more, making you a fortune. The odds against are high but it can and does happen. Under the guidance of Robin Saxby, ARM Holdings (ARM) revolutionised the global silicon chip industry when it developed the fabless and chipless semiconductor model. This means company does not get involved in the difficult and expensive process of silicon chip manufacturing. Instead, it licenses out its processor architectures for a fee and then collects a royalty each time a chip featuring its designs is manufactured. Nineteen years after ARM was spun out of the ultimately-doomed computer company Acorn, the firm still dominates the semiconductor intellectual property (semi IP) market. Following its 1998 initial public offering the shares flew up by 2,320% in their first two years of trading, rewarding those investors who backed the ARM management team’s technological prowess as well as their vision.

Jam tomorrow

Many investors shun the risk involved when buying ‘jam tomorrow’ stocks, which promise huge profits in three, four or five year’s time but in the end often fail to deliver. In his book of 2003, ‘The Innovator’s Solution’, business guru and Harvard Professor Clayton Christensen wrote: ‘Over 60% of all new-product development efforts are scuttled before they ever reach the market. Of the 40% that see the light of day, 40% fail to become profitable and are withdrawn from the market’.

That means just a quarter actually make it to the big time and this risk has to be taken into account when looking for the next Microsoft or Nokia – both of which, it must not be forgotten, had humble origins, in Bill Gates’ garage and as a loss-making Finnish engineering-to-consumer-electronics respectively.

It may seem ever more foolhardy to be looking for blue-sky stocks in the teeth of a recession. But any firm capable of generating earnings growth whatever the economic environment will always be a highly-prized asset. The recent market recovery, which has seen the FTSE All-Share surge into positive territory for 2009, has also seen investors’ once more show an appetite for risk and a willingness to take a chance on a stock making it big. The market plunge seen since 2007 also means many ‘jam tomorrow’ stocks have seen their share prices pounded and market valuations collapse, as investors fled risk and proved particularly wary of smaller firms which were struggling to fund their short-term investment needs. Once-promising prospects such as embedded computer specialist Inova, hand-held device maker i-mate and storage specialist Plasmon have suffered either huge share price collapses or decided to delist or simply failed altogether.

Yet many budding British investment stars are doing just fine, thank you and after two years of stock market falls they could now prove bargain investments.

The rewards

Technology is the area where most investors will look for the next ten-bagger. ARM is certainly sitting pretty with its chips present in 98% of all of the world’s mobile phones, and in spite of the recession putting a damper on the party this is not a product likely to go out of fashion any time soon. Pace (PIC) has seen shares rally nearly 300% this year alone as the manufacturer of digital TV set-top boxes is benefiting from the digital switch-over. Investors should therefore look for punts whose products are easy to use, offer a huge improvement in terms of productivity or quality of service against the

current incumbent product and give the firm a chance to generate high profit margins once past the start-up phase so it can monetise its first-mover advantage.

But there are other parts of the equity market which can also offer money spinning

success stories. Back in 1992 Cairn Energy (CNE) was just another struggling Scottish prospector for oil and gas in the North Sea and Texas, with a few rigs going nowhere fast. A discovery in Rajasthan, Northern India, looked more promising but 50% partner Shell was not convinced. Ten years on, Cairn took the plunge and bought Shell out for £7 million and stepped up its drilling. The rest, as they say, is history. Cairn is now firmly established as a FTSE 100 firm, with oil assets in India, Bangladesh and Nepal and a market cap of £3.2 billion. Those shrewd enough to back the judgement of Sir Bill Gammell, who founded Cairn and was appointed chief executive officer when the firm floated in 1988, have been rewarded with a rise in Cairn’s share price from 193p to £23.48 and a 1,117% return in just over 20 years.

The risks

Running out of money is a common problem for start-up firms which often have to carry heavy research and development (R&D) costs before they generate any sales, let alone any profits. Following an abandoned takeover bid, semiconductor equipment production expert Bede had to call in administrators last year after failing to secure new funding in its efforts to establish industry support for its innovative X-Ray metrology products, despite the presence of industry heavy-hitter Stuart McIntosh on its board. Cash woes, end market volatility and a collapsing share price prompted computer components maker OCZ Technology to leave Aim last month in preference for a US listing. Investors looking for punts must therefore be mindful of companies’ cash burn, and whether their financing, or preferably cash, will keep them afloat through to profitability even if things go according to plan.

Inventing a product that changes or creates a market can be very profitable, presuming customers can be persuaded that they need it – and are willing to pay for it. Eleksen’s failed attempt to develop electronic gadget controls out of fabric proved this point, while Servocell ran out of cash before it could persuade the world its Active Latch electronic locking mechanism really was superior to its traditional electromechanical rivals.

Spotting the winners

‘You need to be extremely mindful of where it can go wrong. If you do that the upside will take care of itself,’ says Justin Jordan, fund manager at Credit Suisse. He points to three characteristics to look for in a growth stock: ‘A company with a niche product or service which means it can grow its earnings faster than the market over a number of years. A company which delivers earnings upgrades. A company and a management team that is being re-rated by the market over time.’

In his final point Jordan addresses the thorny issue of valuation. ARM and unstructured data management specialist Autonomy (AU.) have been fabulous success stories and look set to dominate their respective industries for years to come. Yet neither share is trading within a country mile of the highs seen in 2000 before the technology bubble burst. At 111p ARM stands 90% below its December 1999 bubble high of £10.01 and at £14.59 Autonomy is still way below its November 2000 peak of £34.27, even though both have sales and profits higher than they were nine years ago.

This is because any valuation mechanism has two parts. In the case of the PE it is ‘E’ for earnings for ‘P’ for the price, or multiple, investors are willing to pay to get access to those earnings. After the tech disappointments of 2000-2001, when lofty growth expectations were not met, investors are simply attaching a lower valuation, or ‘Price’, to each company’s earnings stream and cash flow to reflect the risks involved. The shares are said to have suffered a ‘de-rating’ as a result. If the reverse happens – earnings keep surprising on the upside – the stock is perceived as being less risky and it will enjoy the ‘re-rating’ flagged by Credit Suisse’s Jordan.

It is in cases such as these that fortune favours the bold as hype is followed by substance. A strong management team, a product that makes sense, and funding to reach profitability are good places to start. To help investors spot the stars and dodge the duds Shares has analysed five industries which are capable of witnessing the emergence of a new market leader and also highlighted the potential of ten individual firms.

[Note - only included Imaginatik content - more at the Shares web site]

Imaginatik (IMTK:AIM)

Market cap: £6.3 million

Share price: 4.75p

Imaginatik’s collaborative innovation software enables businesses to tap into talent and ideas that otherwise would have been missed. The method both improves processes and saves money for clients, which include a string of international blue-chips. Existing clients reported £170 million in cost reductions over the past two years. This year has seen a string of contract wins across sectors for Imaginatik, and house broker WH Ireland expects 2009 to be the year of maiden profits. (JF)