The Junior stock market has been abuzz with activity as small firms are taking advantage of the benefits of using this medium to raise capital.

Since its opening in April 2009, eight companies have successfully raised funds from local investors. Further, all of these Initial Public Offerings (IPOs) closed ahead of schedule due to oversubscription. The new listings have provided investors with well needed additions to the menu of equity investments. Investor interest was stirred by the growth prospects of these companies as the expansion of current operations and the repayment of expensive debt obligations were the main intended use of funds highlighted in the prospectuses. The companies would also benefit from a 10 year tax concession provided that they remain listed for 15 years. This includes a tax holiday for the first five years of listing and an allowance to pay half the applicable taxes in the remaining five years. Despite the positives, the junior market listings are not without its challenges.

High liquidity levels in the Jamaican dollar money market and the dearth of investment opportunities have made these listings “hot issues”. Investors see an opportunity to buy into businesses in the growth phase of their life cycles. Further, the fact that the additional capital could enhance the companies’ growth potential increased the attractiveness of these stocks because investors can potentially earn higher returns relative to the main market. Companies that have listed so far have outlined dividend policies ranging from 10per cent to 25 per cent of net profit which should augment the total returns to investors. It is not surprising then, that the Junior market index has outperformed the main index, returning 153 per cent for the 2010 calendar year far exceeding the 2.2 per cent return on the JSE Main Index and 13.8 per cent on the Composite Index. Further, one junior market stock has returned as much as 81 per cent over the same period.

Despite their strong performance and high growth potential, investment in these low capitalization companies carries risks including their susceptibility to the fragile economic environment, the small float and consequently low liquidity of these shares.

One of the main risks associated with this type of investment emanates from the fragile economic environment. Due to their small size and relatively less diversified revenue streams, these companies are more susceptible to the downturn in economic conditions than larger, more established companies. Recent earnings releases have highlighted this concern with half the number of companies that have released financial reports since listing, reporting lower earnings for the September quarter or year-to-date. Declining profits could potentially translate into lower dividend payments and a reduction in the overall returns to investors.

Another notable issue is the small float and subsequent low liquidity of these shares. Float represents the number of shares of a particular stock that are owned by the investing public and are available for trading. A common feature of Junior market issues is that only a small percentage of total shares, so far no more than 20 per cent, are made available to the general public. This means that few investors will be able to participate in these IPOs. As a result, trading in these shares tend to be less liquid relative to their main market counterparts. An illiquid stock may mean that the holder will need to offer them at discount when liquidating his holdings.

Investors should also consider that many of these companies remain closely held despite the initial public offering. In this case, most of the company’s shares are controlled by a few individuals. Of note, the founders and board members have maintained a large percentage of the shares even after the listings. In some instances, the founder and related parties own up to 80 per cent of the shares, while in others, the top ten shareholders own over 95 per cent of the existing shares. Because of this, new investors are minority shareholders and there is no guarantee that the rights of minority shareholders will be protected.

The Junior market represents a means for smaller companies to raise capital and has also presented investors with attractive investment alternatives. However, investment in these low capitalization shares is not without risk. We’ve highlighted some of the factors that investors need to consider before taking the plunge into the junior market. Despite the potential to earn attractive returns, like all investments, it is important that investors assess the suitability of these stocks within the context of their risk profile and investment objectives.

Simone Hudson is a Portfolio Analyst with NCB Capital Markets Limited