Making money from small cap IPOs

IPO activity is on the rise again … and it’s often better out than in.

Summary: The number of initial public offerings to hit the Australian stockmarket is a far cry from the boom days pre-GFC, but signs of corporate and investor confidence are increasing as more companies venture back to the public boards. There’s money to be made by investing in IPOs, and history shows that the best way is usually by selling out very early.
Key take-out: Investors who participated in all 15 IPOs this calendar year and sold them at the end of the first day of trade would have made 2.7%.
Key beneficiaries: General investors. Category: Shares.

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.

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%.

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%.

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.

The Uncapped 100

CodeNameRationaleMarket cap ($m)Total return 1-year (%)Sector (GICS)
MMS McMillan Shakespeare One of the best performers since the GFC, but doesn't get much press or analyst coverage. Good management team.1,194,619,26343.85Industrials
MTU M2 Telecommunications Group Amazing growth story and well run company. High free float and strong insto support.1,011,077,75978.3Telecommunication Services
BRG Breville Group Well covered but good candidate for core holding due to good track record.964,006,28778.59Consumer Discretionary
NHF NIB Holdings /AustraliaOnly listed health insurer. Widely held. Good performer.921,908,75243.7Financials
ARP ARB Corp Well covered but good candidate for core holding due to quality management.829,910,88932.54Consumer Discretionary
MRM Mermaid Marine Australia Its strategically located facility on WA coast gives it a key advantage over competition in servicing Gorgon & Pluto projects.791,736,81629.45Industrials
SRX Sirtex Medical A shining star in the biotech space and one of the best performing stocks in 2012. Great product (liver cancer treatment) and bright outlook.691,524,902108.76Health Care
GEM G8 Education Only listed childcare operator. Acquisition strategy paying off with stock delivering solid gains.677,657,532186.56Consumer Discretionary
AAD Ardent Leisure GroupWidely held stock. Earnings more defensive than anticipated. Good yield. Potential core holding668,310,66938.79Consumer Discretionary
AUB Austbrokers Holdings The insurance broker is a strong performer. Widely held and well liked by small cap investors.636,149,84165.27Financials
ACR Acrux One of the most successful Australian biotechs in recent history. Widely held by instos.601,143,372-20.06Health Care
SGN STW Communications Group One of few companies able to benefit from online shift. Widely held and good insto support.579,493,89663.67Consumer Discretionary
BDR Beadell Resources Will be a very big FY14 for miner as it has to prove it aims to produce 200,000 ounces of gold a year.507,277,832-4.44Materials
RFG Retail Food Group Owns a number of well know franchise brands. Widely followed by instos.485,936,40152.95Consumer Discretionary
NXT NEXTDC The cloud computing company is an IT sector darling. Fairly widely held and followed.478,576,26349.17Telecommunication Services
TOX Tox Free Solutions Widely held stock in the waste solutions business. Its unique because it operates in a defensive-growth niche.453,217,92650.26Industrials
AMM Amcom Telecommunications Well covered junior telco but good candidate for core holding.441,425,56872.94Telecommunication Services
CCV Cash Converters International Strong performance is attracting investors. It's Australia's only listed pawn shop and pay day lender.440,815,46080.09Consumer Discretionary
CCP Credit Corp Group Strong price run attracted good investor interest. Leveraged to any rise in loan defaults. Not well covered by press.429,472,62665.71Industrials
HZN Horizon Oil One of better regarded small energy stocks that doesn't receive much media attention.425,724,94533.93Energy
BGA Bega Cheese Corporate interest in Australian food companies makes the cheese maker worth following.403,963,71572.5Consumer Staples
SEA Sundance Energy Australia Analysts have a favorable take on the oil & gas explorer, but stock is still under radar of most. Sundance provides exposure to prospective Eagle Ford shale.396,275,11652.21Energy
SLX Silex Systems Its uranium enrichment technology could become one of Australia's best innovations given its potential to change the nuclear power industry.377,953,125-33.33Information Technology
MYS MyState Well regarded and could make good alternative to bank stocks. Has good yield and earnings growth over past few years.370,400,45250.42Financials
CWP Cedar Woods Properties Property developer with good ROE and earnings growth track record.364,596,95448.25Financials
BRU Buru Energy Substantial size but not often covered by press. Widely held with good insto support.358,987,701-59.06Energy
FGE Forge Group One of the better performers in its industry. Good track record and potential core holding.352,431,274-12.78Industrials
RKN Reckon Fierce competition for cloud base accounting software puts it in firing line.313,360,99221.41Information Technology
TGA Thorn Group One of few retail stocks that is performing well. The Radio Rentals chain owner is also well supported by instos.308,719,72749.45Consumer Discretionary
UXC UXC Company has turned corner and enjoyed re-rating. What's next?307,262,60484.86Information Technology
UNS Unilife CorpThe developer of one-use prefilled syringes is close to an inflection point as the market is expecting the company to announce a major contract with a pharmaceutical giant in the coming weeks.306,530,853-29.56Health Care
RCR RCR Tomlinson Good first half FY13 result and outlook, but will its fortunes change this year with the mining capex slowdown?284,727,23434.76Industrials
MOC Mortgage Choice Has a good track record and is leveraged to any housing recovery. The stock is also liquid with good insto support.274,017,45683.06Financials
NWH NRW Holdings One of the better regarded mining & civil contractors with good track record in delivering on projects.257,971,405-66.17Industrials
AEU Australian Education TrustWell performing childcare centre property owner. Good yield story and outlook. 257,056,82455.11Financials
MYX Mayne Pharma Group Sizeable generic drug maker with interesting board members.242,071,28967.53Health Care
IMF IMF Australia Litigation funder is unique stock. Stock not liquid but its outlook appears promising given the number of potential class action lawsuits.241,475,37252.86Financials
SPL Starpharma Holdings Noteworthy for its good pipeline of innovations. Well run, widely followed.226,932,755-39.85Health Care
RIC Ridley Corp High corporate interest in the sector and the shrinking pool of agri listed stocks make Ridley worth following.226,245,575-22.72Consumer Staples
AJA Astro Japan Property GroupStrong leverage to Japanese economy makes this an interesting stock to watch.219,110,30618.19Materials
WBB Wide Bay Australia The building society is trying to turn its fortunes around. Also worth watching for its exposure to Queensland housing market, particularly around major resource projects.215,982,05610.72Financials
PFL Patties Foods Illiquid stock but has suite of well recognised consumer brands. Defensive yield.211,379,776-1.83Consumer Staples
NWT Newsat Potential large cap if it can launch its own satellite in 2015.202,341,934-45.65Telecommunication Services
SIV Silver Chef Strong jump in the share price of the equipment financing group has attracted a good following.201,339,218126.4Industrials
MXI MaxiTRANS Industries Transport equipment maker posted good interim result. Has appealing yield and growth.200,552,81188.1Industrials
DWS DWS Will be a big beneficiary if governments start spending on IT again.191,264,20610.02Information Technology
SHV Select Harvests Noteworthy for turbulent past and exposure to soft commodity market.180,433,365154.91Consumer Staples
GXL Greencross Acquisitive vetinary group. Good profit growth and share price performance, but gets little press.177,656,738119.71Health Care
GXY Galaxy Resources Good upside potential if it can get its problem-prone Jiangsu plant back on track. Won't be easy to right this ship.177,430,000n.a.Materials
MLB Melbourne IT A perennial underperformer could be interesting turnaround story as management is in midst of restructuring the business.175,732,17833.69Information Technology
VOC Vocus Communications Telecom stocks are in favour but Vocus is one of the least covered174,358,55112.37Telecommunication Services
GID GI Dynamics IncLargely forgotten by investors but could attract attention this year as it looks to gain US approval to use its intestinal shealth on diabetics.171,796,188-31.82Health Care
DTL Data#3 Well respected IT company that receives little press coverage167,832,7038.82Information Technology
CLH Collection House In similar space as Credit Corp. Strong stock performance has attracted a following and the stock appears to be well placed to run further167,366,60896.05Industrials
SFH Specialty Fashion Group In early stages of turnaround. Can the women's apparel retailer sustain the momentum?160,517,15160.75Consumer Discretionary
CKF Collins Foods One of the few food franchise listed companies.156,240,00568.3Consumer Discretionary
NAN Nanosonics A successful medical tech story. Should be close to turning in maiden profit with its disinfection device.150,643,50916.16Health Care
BNO Bionomics One of the larger cancer treatment developers in this market.150,035,08016.55Health Care
HSN Hansen Technologies Operates in a high potential/growth industry but is not covered by press or brokers.146,065,6597.76Information Technology
IMD Imdex Drilling company is well supported by instos and should benefit from any rebound in exploration activity.143,121,765-61.59Materials
TGS Tiger Resources Future lies in its Kipoi copper mine expansion in the Congo but miner is fully funded with DRC govt holding 40% stake in tenement. Next 12mths will be interesting.141,701,752-22.22Materials
RCG RCG Corp The footwear retailer is one of the best performing consumer stocks as online competition is not a big threat. Company has a good yield as well.138,348,77074.6Consumer Discretionary
IFM Infomedia Interesting tech play in the car parts market. Strong share price gain but gets little air play.138,127,472142.83Information Technology
POH Phosphagenics Sizable biotech with a game changing FY14 year ahead. Good insto following.137,762,909-15.63Health Care
REX Regional Express Holdings Well run airline that is overshadowed by Virgin and Qantas.137,018,03614.17Industrials
IPP iProperty Group Worth watching as it is trying to be the REA Group of Asia.131,372,177-22.87Information Technology
MCP McPherson's The personal care and household products supplier had been relatively insulated from volatile discretionary spend and online threat, but its latest profit warning shows it's not immune.129,476,593-10.27Consumer Discretionary
TFC TFS Corp The sandalwood products company offers exposure to both the agri and cosmetics industry. It will start commercial harvest this year.116,043,060-7.78Materials
UBI Universal Biosensors IncWell regarded biotech and one of few that's successfully manufacturing in Australia. Struck deal with a few global medical companies.110,066,93312.5Health Care
NEA Nearmap A stellar performer with an Interesting business that offers high quality ariel maps to companies & government.106,608,521633.33Information Technology
CLV Clover Corp One of the star performers in 2012. Operates in growing but relatively stable niche.102,412,65174.49Health Care
ACL Alchemia /AustraliaOne of the few biotechs with revenue stream. Good pipeline of oncology treatments.98,833,366-32.22Health Care
ESV Eservglobal Mobile money transfer company that has been gaining traction. Widely held by instos but low press coverage98,373,16975.56Information Technology
BGL BigAir Group The wireless microcap has gained strong following over past year or two but is often overlooked by investors and the press.95,923,06566.15Telecommunication Services
SAR Saracen Mineral Holdings Emerging gold producer that is widely held by instos. Hitting milestones and looks cheap. Key asset is close to gold majors, which makes it a potential takeover target.95,242,111-72.65Materials
AMA AMA Group Good turnaround story but under the automotive services group is radar of most.92,802,856114.22Consumer Discretionary
LCM LogiCamms Strong price performance and reasonable valuation attracting interest.88,972,72522.8Industrials
AOH Altona Mining Noteworthy copper play with Xstrata pullout of Roseby project in Australia and the good ramp up of its Finnish project.84,638,832-39.62Materials
AZZ Antares Energy Liquid with good insto support. Already in production with exploration upside in Texas.84,150,002-20.48Energy
PEN Peninsula Energy Widely held by instos and large free float. It's the only uranium miner on the list.76,842,873-25.71Materials
CUV Clinuvel Pharmaceuticals Interesting skin disorder treatment developer that has done reasonably well over past year76,242,98920.91Health Care
CAA Capral An aluminium manufacturer that is actually holding up relatively well given that manufacturing is on the nose. 73,030,28132.14Materials
RUL RungePincockMinarco IT company to resource industry. Turnaround potential under new CEO.70,672,60737.84Industrials
DRM Doray Minerals Widely held by instos. One of the more favored gold explorers by brokers.69,514,717-46.69Materials
TAN  Tandou The only direct equity exposure to cotton prices. Also trades water rights and receives little press.60,128,7885.21Consumer Staples
JIN Jumbo Interactive Innovative small cap facing off industry dominated by giants. Worth watching to see if it can carve out a profitable global business.59,449,24514.62Consumer Discretionary
CKL Colorpak The small cap packaging company has grown via acquisitions over past few years.57,076,00421.5Materials
UML Unity Mining Growing Tassie gold producer with high free float. Valuation looks compelling too.54,053,829-38.4Materials
LGD Legend Corp Electronic parts supplier to utilities and other industries. Stable earnings with good yield. Often overlooked.53,777,561-18.25Information Technology
WDS WDS Widely held with strong insto support. Engineering contractor diversified across mining, energy and infrastructure.53,554,028-15.93Industrials
BOL Boom Logistics Crane hire group is riding out the downturn in construction.  It's widely held by instos and is very liquid.51,765,842-51.11Industrials
KOV Korvest The construction products and services supplier has been hit by project delays and deferrals. But its relatively high yield could give it some support.50,685,45235.36Industrials
YTC YTC Resources Next 12-mths will be eventful after YTC secured funding for its projects from Glencore.45,870,007-33.96Materials
ISS ISS Group Good turnaround story from 2012 but the resource industry software developer under the radar of most. ISS has received a takeover offer after its inclusion in the Uncapped 100.43,568,27597.88Information Technology
TSM ThinkSmart Potential turnaround story worth keeping eye on.41,408,57713.04Financials
NTC NetComm Wireless Under appreciated small IT hardware maker that is punching above its weight. Hardly covered by press.31,589,05492.59Information Technology
OTH Onthehouse Holdings Alternative small cap to online property leader REA Group. It is trying to use more timely housing data as a compeitive edge against REA.28,761,225-14.92Consumer Discretionary
EBT eBet Potential alternative to star performer Ainsworth Tech. Has exclusive deal with US poker machine maker WMS.19,921,261106.35Consumer Discretionary
MBO Mobilarm Unique product that could change global maritime safety practices with its man-overboard location beacon.12,581,549#N/A N/AInformation Technology
PGC Paragon Care Emerging hospital equipment supplier that has been ignored by market.10,583,66729.55Health Care
Source:Eureka Report, Bloomberg