10 things you must know about IPOs to make money

 

Having written about hundreds of floats over the years, I have come across many terrific companies that have used the IPO market for its true purpose: to raise capital to grow faster, not as a quick exit for vendors.

Of course there are reasons to avoid IPOs, particularly the ones which are purely money making ventures, but generalising about the IPO market, or any sector for that matter, is dumb.

Every company must be treated on its merits. For example, fund managers who moaned about private-equity vended floats after the disappointing Myer Holdings float in 2009 and Collins Foods float in 2011 missed stellar private-equity IPOs such as In Vitro Fertilisation provider Virtus Health.

Another IPO benefit, especially in this market, is portfolio diversity. A feature of 2014’s record-breaking IPO market is the emergence of companies from new sectors or those poorly represented on ASX: healthcare, education, software and service companies are examples.

Every now and then, a different offering comes along: Genworth Mortgage Insurance Australia provided the first specialist exposure to mortgage origination; IPH Ltd gave the first exposure to intellectual property law; and iSentia Group to media-monitoring software. Each added different industry exposure to portfolios and soared after listing.

Also, successful IPO investing can boost returns for self managed superannuation funds and other long-term investors, improve portfolio diversification, and give DIY investors great satisfaction from backing high-growth companies at the next stage of the growth journey.

But there are plenty of tricks and traps and other IPO traits that rarely get covered in mainstream commentary. Here are 10 IPO considerations for retail investors:

1. Know the odds

Cadence Capital founder Karl Siegling says one in every 10 IPOs are worthy investments. Assuming 80 IPOs in a good year, investors will have eight floats on their radar, but perhaps only get their desired stock allocation in two or three. Getting stock in the best floats is beyond most retail investors, especially those who do not have a relationship with big investment banks.

2. Know the IPO cycle

Good and bad companies can be found in all parts of the IPO cycle. As a rule of thumb, better-quality, better-priced floats typically come to market earlier in the IPO cycle, which began in earnest last year. Professional investors usually dominate the early part of the cycle: nimble private-equity firms vending assets to fund managers. Retail investors are often harder to find in the early stages of an IPO market recovery.

Lower-quality, more aggressively priced IPOs typically emerge in the later stages of a bull market, when some corporate advisers will “float a cork” if it means advisory fees. By then, retail investors are back in the IPO market in force and, sadly, loading up on too many bad ones.

The cycle is not always clear-cut, but it pays to think about broader IPO trends. This cycle looks like it is about halfway: retail investors are starting to return to the IPO market, largely because of the Medibank Private IPO and the success of the larger IPOs such as Healthscope.

But IPO “fatigue” is emerging. More floats were abandoned, repriced or delayed in the fourth quarter because of the sheer rush of float activity. The best of the IPO market was probably in 2013 and 2014, although there will always be opportunities for value hunters.

3. IPO or aftermarket?

Too many investors give up on IPOs when they cannot get stock, even though the best opportunities are often in the aftermarket, six to 12 months after the company lists.

By then, the IPO has more history as a listed company, greater compliance with ASX Listing Rules, and time under the market’s gaze. Investors can better judge whether the prospectus was fact or fiction and if the company is doing what it said it would. The best floats rally long after listing; giving up some early price gains and reducing risk, by buying in the aftermarket, often makes sense.

4. The debut

In years past, investors expected the mandatory 10% “stag” on debut, as the vendor underpriced the stock to leave something on the table for others. These days, hedge funds and high-frequency traders are creating different IPO dynamics.

There is talk of US hedge funds dumping IPO stock on debut if it drops below the issue price and momentum traders selling if the early share-price trend is down. There seems to be a lot more turnover in IPOs on debut as traders get in and out, and then a quieter aftermarket in some floats.

The upshot is good IPOs can be dumped on debut for no other reason than the price quickly breaching some technical level determined on an offshore computer program. That creates opportunities for patient capital to move in when short-term owners have left the register.

5. IPO or listed peer?

Investors can put all their focus into an IPO, overlook its nearest listed peer, and miss opportunities. For example, those who bought Steadfast Group might have overlooked Austbrokers Holdings, a more established, successful listed company. Those who clamoured for Healthscope might have paid less attention to Ramsay Health Care.

Always compare an IPO with its nearest listed peer – in most cases it should trade at a discount, although in this market many IPOs get away on Price/Earnings multiples similar to those of their nearest listed rivals, or in some cases even higher.

Moreover, watch how the listed peer trades in the lead-up to its rival’s IPO. Fund managers that have to be fully invested in equities will sometimes take profits in an established company to free up portfolio funds to invest in the IPO. The IPO’s listed rival could be the better investment.

6. Know who is selling

The single most important piece of information in any float: who is selling, why, and what are IPO funds being used for? Do the vendors still have “skin in the game” or are they making a quick dash for the exits, via an IPO? How aligned are the vendors with new shareholders after listing? Are IPO funds being reinvested in the business or mostly going back to the vendors?

After a few private-equity IPO fiascos (Myer, Collins Food etc), the market generally required vendors to hold more stock after listing, and sell down less through the float. That cuts both ways: the vendor has more to lose, but equally more stock to sell at some point, as is the case with several floats from 2013 where private equity still has a big stake that has to be sold.

Billions of dollars of “block trades” will need to be absorbed in 2015 as private equity in floats such as Nine Entertainment Co. Holdings look to exit.

7. Know who is buying

Waiting to see who bought into the IPO is another reason why it often pays to buy in the aftermarket. Examine the top 20 shareholders after listing; the better-performing funds, especially specialist small-fund investors, often get stock in better-quality IPOs as vendors try to build a strong share register of long-term institutional capital. Or there might be prominent cornerstone investors who get access to better deals.

It’s not foolproof, of course. But investing in an IPO that has high-calibre institutional investors on its share register means there has been serious due diligence and that there is a base of investors that will subscribe to future equity capital raisings if the company performs.

8. People

Like any share investment, it pays to examine management and the board. Don’t fall for the glossy bios in the prospectus: nothing tells you more about the executive team’s calibre and ethics than the capital structure. Companies with excessive options issuance and easier hurdles for options to vest (usually based on the flimsy metric of share-price target) provide clues that the management and board are potentially gouging investors.

Challenging performance targets for executives based on profitability measures rather than share-price targets are a good sign. So is a board with a high proportion of independent directors who are there for their skills rather than their profile, and capable of holding management to account, rather than being captured by it.

9. Future share issuance

Study the capital structure carefully to understand how many shares could be issued if all options or performance shares are granted. Shareholdings can be badly diluted if a wall of new share issuance emerges a year or two after listing, which weighs on return on equity.

With smaller floats, pay particular attention to restricted securities that ASX deems cannot be sold until a certain time has elapsed (the escrow period).

Escrow dates, usually a year or two after listing, can be accompanied by a wave of selling as original investors are allowed to sell their shares. That’s fine if there is sufficient buying to absorb the selling, but too many early investors heading for the exit at the same time can crunch the share price.

Voluntary escrowing of shares, sometimes by company founders, cornerstone investors or directors, is usually a good sign. It shows the company’s backers are willing to hold their shares longer than they have to, thus better aligning their interests with new shareholders.

10. Usual rules apply

Focus on IPOs in faster-growing, attractive industries: healthcare, education, software and service floats have been popular this year because they have the potential to outperform in a weakening economy. Choose companies with a clear, sustainable competitive advantage or “economic moat” that makes it harder for rivals to compete against.

Favour IPOs that have a strong business model, are profitable, have potential for a high return on equity (above 15%), strong cash-flow growth and low debt. Seek small-cap companies with, or potential to have, a global footprint, as their growth prospects in a limited Australian market can be quickly exhausted.

On valuation, assess how their forecast PE compares with similar listed peers here or overseas. In theory, the IPO should trade at a reasonable discount to larger, more established listed peers.

Top ten IPOS

These IPOs caught my eye in 2014. Several have rallied sharply since listing and look fully valued, but are worth considering on any share-price weakness or broader market sell-off. Others make the list on valuation grounds after post-listing share-price weakness.

– Genworth Mortgage Insurance Australia
– Intellectual property lawyer IPH Ltd
– Media-monitoring technology provider iSentia Group
– Labour hire firm Ashley Services Group
– Monash IVF Group
– Intueri Education Group
– Car-parts distributor Burson Group
– Japara Healthcare
– Beacon Lighting Group
– Dental provider Pacific Smiles Group

Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at December 10, 2014

Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.

Follow the Switzer Super Report ^[1] on Twitter