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What to consider if you’re thinking about buying into an IPO

Uber floated in May 10 at $US45. It is now worth about $US43.50. Photo: Getty
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A company’s decision to float on the Australian Securities Exchange (ASX) is typically done together with an initial public offering (IPO).

This IPO allows them to raise funds needed to expand the business.

That’s great for those responsible for bringing a company to market, but not always great for you.

An IPO can provide a ground-floor opportunity to acquire tomorrow’s ASX leaders before future growth is factored into the price.

But the opposite is also true, and based on the ASX’s recent past, you’ve got a 50-50 chance of an IPO being valued at less than what you paid within the first 12 months.

First the history lesson: The ASX is littered with examples of floats that didn’t make shareholder’s money, either short term or even over the longer haul. For example, retailer Myer Holdings (ASX: MYR) share price has bounced its way to $0.57 from its $4.10 issue price in October 2009.

Fast forward to 2018 and 70 per cent-plus of the share prices of the companies that listed on the ASX were by year’s end in the red.

However, two standout IPOs from last year were UK miner Adriatic Metals (ASX: ADT), and hemp oil producer Elixinol Global (ASX: EXL), currently up 157, and 151 per cent respectively.

So how can you ensure you back the next JB Hi-Fi (ASX: JBH) or Domino’s Pizza (ASX: DMP) instead of future share market debris?

The trick to weeding out quality IPOs from duds, claims Bruce Apted senior portfolio manager at State Street Global Advisors is avoiding overpriced and over-spruiked companies wired to lacklustre sectors with questionable growth projections.

When considering any IPO, Mr Apted said the long term was a much better approach than trying to sell immediately after the IPO for a quick profit – aka ‘stagging’.

The trouble with any company’s glossy (IPO) prospectus, added Mr Apted, is that it’s basically an advertising document, and that the brokerage/investment bank underwriting the IPO are salespeople.

Equally important, he says investors need to remember that there are no philanthropic motives when companies decide to float their stock.

“If the [IPO] prospectus doesn’t provide full transparency, you don’t have the information to assess the business and are unable to make an informed decision,” he warned.

Ideally, you should be attracted to the floats of companies with consistently above-average return on equity (ROE), with little debt and not too much goodwill on the balance sheet.

whether or not to buy into IPOs
Rideshare company Lyft floated at $US72 in early April. It is now $US59. Photo: Getty

But given that these measures provide an incomplete picture, the better way to pressure-test any IPO, Mr Apted added, is to:

  1. Understand the business model in the context of its competitive environment
  2. Examine the likelihood of the company generating consistent profits
  3. Investigate the potential future risks to the business.

Echoing similar concerns, Nathan Bell, portfolio manager at InvestSMART, recommended treating IPOs like any other ASX stock, and if there’s no clear path to profitability, don’t buy it.

“If it’s private equity that’s selling, you’d do well to run a mile,” Mr Bell warned. “Usually they load the business up with debt, don’t spend enough on capital expenditure to show low depreciation and high historical earnings figures that aren’t sustainable.”

He encourages you to ponder the immortal lines of Warren Buffett, the world’s most successful shareholder, when he quipped: “It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less-knowledgeable buyer”.

If the insiders who know the business backwards are selling, Mr Bell pondered, ask yourself why you’d buy from them?

He recommends investigating previous financial statements of companies planning to float, to find out:

  1. If IPO forecasts of future revenue look realistic
  2. Whether the money raised is being earmarked to fund expansion or repay debt
  3. The amount to be paid to existing owners.

“Check insider-selling escrow periods and how many shares are in escrow,” urged Mr Bell.

“Often the amount is small compared with the initial sale through the IPO, and the escrow period also makes it look like the insiders are heavily invested when they’re not.”

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