Making money from small cap IPOs

This is shaping up to be the best quarter in 2½ years for new floats, as the most trumpeted new listings of the year have generated enviable returns for investors.

If online health insurance broker iSelect (ISU) enters public life next Monday as scheduled, its $215 million float would take the total value of new initial public offers (IPOs) to just over $1 billion for the June quarter, which would mark a record amount since the final quarter of 2010.

While that may not be saying much given that the IPO market is coming off a low base and the market volatility is clouding the outlook for new listings, there is clearly good investor appetite for these stocks as the largest floats this year have surged since their market debut.

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Fertility service Virtus Health (VRT), which is the biggest with a market capitalisation of $500 million, is up 14% from its IPO offer price; while law firm Shine Corporate (SHJ), property trust Arena REIT (ARF) and data facilities owner Asia Pacific Data Centre Group (AJD) have produced returns of 46%, 4.5% and 12%, respectively.

But the best performing listing this year is Indoor Skydiving Australia Group (IDZ). The skydiving facilities developer has thrilled investors, as they have seen their investment double in value in just five months from the 20 cent offer price.

The question now is whether you should take the leap into the next IPO, and if making money from new stocks is as easy as these examples might lead you to believe.

Since new listings mostly fall into the small caps arena, I thought I would try to answer these questions by looking at past IPOs, and the findings could hold important lessons for both long- and short-term investors.

Making a profit from “stagging” an IPO (applying for a new stock and selling it on the first day of listing) isn’t an urban myth that should only be pursued by risk-tolerant investors, if history is any guide.

Interestingly, stagging could be the lower-risk strategy for those looking to buy into an IPO.

If you blindly participated in all 15 IPOs this calendar year and sold them at the end of the first day of trade, you would have made 2.7%. That may sound a little skinny, but considering your capital is only tied up for a couple of weeks (between the time you apply for the stock and when it debuts), your annualised return is probably well north of 30%.

If you used the same strategy on the last 300 IPOs over the past five years, you should have made a more handsome 10% average return, and you don’t need to annualise that to make it look impressive.

However, history would further suggest that you do not want to be holding on to new stocks for more than a day or two, as the average performance deteriorates quickly. After a week, new stocks would lag the broader market by an average of 0.1%, and by the six month mark, they would be behind the market by 2.6%.

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There are many reasons why a new stock could struggle over the short- to medium-term, and finding common drivers to explain this is difficult. But if I had to make a general observation, I would say that new entrants are usually at a disadvantage compared with their more established rivals, which tend to be larger and better understood by the investment community. Only when, and if, the newbie develops a sustained track record will the discount gap close.

But this isn’t to say that longer-term investors should shun all new listings. It sounds obvious, but the key point here is to do your homework. This is particularly important for IPOs, because only around a third of new stocks actually outperform the ASX All Ordinaries Index in the first six months of their listing.

However, when these stocks get it right, they really get it right. Picking the right IPOs will yield you an average total return that is 52% ahead of the market at the 180-day mark, while the laggards underperform by an average of 33%.

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This brings us to the question of what makes a good IPO? In this turbulent environment, newly listed companies with reasonably defensive and predictable earnings are “in”, while speculative cyclical stocks are “out”, according to Bell Potter Securities’ head of research, Peter Quinton.

“If [the new listing] is from one of those defensive sectors where it has got some protection from slowing economic growth, I think automatically people will look at it very closely,” said Quinton.

“But as a start, IPOs need to be priced at a discount to their peer group; and all things being equal, my rough [estimate] is that the price-earnings [P/E] will need to be 10% lower and the yield 10% higher [than their peers].”

But valuations are last on Quinton’s checklist as qualitative analysis is more important. The things he looks for first are:

• If the vendor is keeping any shares (company founders keeping some skin in the game is seen as a positive);
• The composition of the shareholdings;
• The outlook for the sector over the next two to three years, and
• If the company forecasts outlined in the prospectus look reasonable.

He also tends to avoid IPOs where the company has bought a couple of other businesses to appear bigger, as this strategy has produced more failures than successes.

Looking at the much anticipated iSelect float, the IPO ticks most of the boxes but there are small cracks in the story that leads me to suspect that investors will be better off stagging the IPO and looking for a better entry price down the track.

“When they first priced the IPO, I thought it was quite attractive,” said Prime Value Asset Management’s portfolio manager, ST Wong.

“But what has happened post the lodgement of the prospectus was that the listed internet companies suffered a sharp dip.”

For instance, shares in Trade Me Group (TME) and Carsales.com (CRZ) have fallen over 10% in the past month and are trading on a 2013-14 P/E of around 21 times and yield of 3.7% each.

At the offer price of $1.85, iSelect is around the same multiple and the company is not planning on paying a dividend for the next couple of years as it focuses on growth.

Further, Wong commented that the quality of iSelect’s balance sheet and cash flow is not as good as established online stocks, and Medibank (our largest health insurance provider) does not provide cover through the iSelect website.

Prime Value is participating in iSelect’s IPO. Maybe what the market really needs is a comparison website for new share issues as IPOs aren’t only for the stags.

Brendon Lau does not hold any of the stocks mentioned in this article.