Only occasionally does float hype meet reality. For every Microsoft there is a Groupon, a Facebook and a Webvan.
The problem is that while the failures drift into distant memory, the raging successes burn into our consciousness. That’s why so many investors find initial public offerings (IPOs) hard to resist. And it's why so many get burnt.
So here’s a three-step checklist to help you find the next Microsoft while avoiding the Webvans and Groupons.
- IPOs often make poor investments
- Understand what is being sold, who is selling and why
- Often best to wait three years after listing for problems to be revealed
1. If you’re buying, someone is selling. Who are they?
In an Investor’s College article titled Seth Klarman: Lessons from a legend we explained why knowing your buyer is almost as important as knowing what you are buying. For IPOs, that’s especially pertinent.
The odds are stacked heavily against prospective IPO buyers. The typical list of IPO sellers can include private equity owners, company insiders, company founders and large parent companies. All know the business, the industry (and its cycles) inside out, often exiting at a time when the market will bear extremely high valuations.
Economists call this information asymmetry. A glossy prospectus full of numbers and notes offers the impression that investors have all the information at their fingertips. But it’s written by the sellers and doesn’t compare with the knowledge they've acquired through their association with the business (the financial history provided in a prospectus, for example, is usually limited).
Private equity investors deserve special mention here. Can an individual investor really gain an edge over such sellers?
Consider Penrice Soda Holdings, Kathmandu and Myer, all private equity sales. Since listing, these stocks are down more than 95%, 30% and 55% respectively. The modus operandi is straightforward enough: Sell assets, increase leverage, strip out the costs, reduce capital expenditure and get rid of it before it has an effect on sales. Short-term owners don’t have much interest in long-term business performance.
Table 1 shows data from Penrice Soda Holdings float in 2005 that had an application price of $1.93 per share. It nicely illustrates the point. See how depreciation was low as the company emerged from private equity ownership but then capital expenditure exploded in 2008 and 2009? Then see how depreciation charges, which were the more accurate picture, increased. This was a business being pared back for sale, the consequences of which only became visible after the sellers were long gone.
|Year||Depreciation charges||Capital Expenditure|
Penrice Soda was floated by private equity investors Quadrant Capital, which made a 250% return on its investment. In contrast, Penrice now trades below 10 cents per share, 95% below its application price.
On the other hand, buying from distressed sellers (such as highly leveraged parent companies, governments or company insiders keen to move on) can be lucrative. The performances of CSL, QR National and Commonwealth Bank, but not Telstra, are all good examples, as is Cochlear which was sold off by Pacific Dunlop. Governments and banks are rarely renowned as shrewd sellers (partly because governments sell to their voting constituents), which is why distressed asset investors such as Klarman are currently circling Europe’s banks.
Governments and large businesses wishing to divest an orphan operation can be generous sellers; most sellers, however, aren’t.
2. What are the reasons for owners selling out?
Almost all floats have a hidden agenda. Unfortunately, rarely is it to present individual investors with the bargain of a lifetime.
Raising capital for expansion, paying down hefty debt loads, taking advantage of cyclical peaks and selling out at astronomical valuations are just some of the long list of hidden reasons sellers will want you to part with your dough.
Consider the frenzy of the highly leveraged American and Japanese real estate investment companies listing on the ASX in the early 2000s, such as Rubicon Japan Trust, Babcock & Brown Japan Property Trust (now Astro Japan Property Trust) and Galileo Japan Trust. Now why would Japanese or American investors list their lucrative assets in geographically distant Australia if not to take advantage of local investors? Rubicon went bust, Galileo is struggling to stay afloat and Astro’s security price is a fraction of what it was after adjusting for a 1-for-10 security consolidation.
Sellers want to get out at a time when they can get the best prices. That means many IPO investors are buying in at the top.
3. Can you really believe the prospectus?
An IPO prospectus has to meet a raft of legal requirements and disclosures, which gives it a veneer of respectability. Scepticism is often more warranted, with earnings forecasts often the most misleading data of all.
Consider the term ‘hockey stick' earnings projections. It describes a diagram in which revenues and earnings projections are about to take off. To paraphrase an old economist's maxim, ‘the only reasons earnings projections by IPO underwriters exist is to make astrological projections by clairvoyants look good.’
Buying into a basket of 10 or so random IPOs is more likely to see an investor lose their shirt than earn a shortcut to retirement. As Warren Buffett once said, ‘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.’
Now you know the three key questions to ask to avoid that fate.