Initial public offerings (IPOs) can be rewarding. In June, Virtus Health floated on the sharemarket with an issue price of $5.68. Its shares now trade at about $8.60. But buying into a float is riskier than buying shares in a business that has a track record as a listed company.
Listed companies have to disclose more information about themselves than private companies.
High demand for an IPO is no guarantee of success. An example is iSelect, the online insurance comparator, which floated in June with an issue price of $1.85 and whose shares are now trading at about $1.35.
First and foremost, a company's business model has to make sense, says Brian Eley, the co-founder of the small companies specialist Eley Griffiths Group.
"Then we ask ourselves why are the owners selling it," he says. He prefers to see the money raised by the float used to grow the business. And he wants to be satisfied about the quality of the management.
"Most retail investors do not get to meet management, but we do. We size them up, we try and establish their motivations and competence, vision and track record."
The identity of the broker facilitating the float is also important. "Does the broker have a track record of filtering good prospects from bad prospects or does it float anything for a fee?"
Eley is sceptical about a business's prospects being talked up when that business has been plodding along for years.
"We look for accounting quality and whether the cash flow matches the profit," he says. "As a wise man once said, profit is a matter of opinion but cash flow is a matter of fact."
Steve Black, the manager of the Pengana Emerging Companies Fund, says the best time to invest in IPOs is at the start of the cycle when better-quality businesses are listed.
"We find the quality wanes the longer the cycle continues as promoters begin pushing more questionable business models," he said.
Black is attracted to companies with proven cash flows and stable management. He prefers to see management aligning its interest with shareholders and not selling down too much equity.
Eley says pricing of IPOs is vital. If the company's shares are being issued at a price-to-earning ratio that is higher than other companies in the same industry, you need to ask yourself why, he says.