IPO's not all they seem

David McEwen

David McEwen is managing director of Investment Research Group

Initial Public Offerings – not all they seem

We are seeing a few Initial Public Offerings (IPO’s), which is good for the NZ share market, and good for the company raising the capital - but not always good for the investors.
You need to be careful particularly as we are at a market peak and some strange companies get listed in this phase. Anyone who was around in 1987 will remember a time when any failed family business could be written up in a prospectus, dressed up with some nice pictures and elevated with some outrageous forecasts, and listed into a hungry market.

The high share market attracts the founders of businesses that see an opportunity to effectively sell off part of the business at a very good price, while lowering the cost of capital used in their expansion. In this phase some outstanding family businesses get listed, and we have seen several.  But there are also very bad ones.

There are two kinds of offers: The kind where small punters are urged to apply for as many shares as they can get, and they succeed in getting all they want; and the kind where the punter cannot get into the action at all because all the shares seem to be going elsewhere.

Canadian analyst Norm Rothery, (Ph.D.) studied the IPO phenomenon and came to the conclusion that in very hot IPO’s the shares are sold to institutional investors "who in turn quickly sell them to the public and pocket their gains." The bulk of hot IPO stock goes to the brokers' best clients and other insiders, he says. Only the dregs are left for main street investors.
“After all, institutional investors generate huge commissions for brokers and when it comes to handing out perks like hot IPO shares these big traders demand a big slice of the pie. The process might not be equitable but it has been this way for a long time." It also nicely illustrates, he says, why most main street investors should avoid IPOs entirely. Regular investors rarely get quality IPO shares before public trading begins. On the other hand, buying at sky-high prices when trading starts can set up investors for a big fall.

Professor Jay Ritter of the University of Florida has collected a vast array of historical data on IPOs. Ritter's research indicates that IPOs typically move smartly higher from the IPO price in the first day of public trading. First day gains for U.S. IPOs averaged 18.1% from 1960 to 2005. In Canada, first day IPO gains averaged 6.3% from 1971 to 1999.

While Professor Ritter tracks first day IPO gains, he also follows the new companies for the next five years. Five-year average annual gains for U.S. IPOs, after the first day of trading, came in at 10.7% from 1970 to 2003. At first glance a 10.7% gain might seem great but IPOs trailed far behind similar stocks. Over the same period, stocks of a similar size outperformed the IPOs by an average of 4.1% annually which is a huge difference.

"The lesson is fairly clear" says Rothery, "in most cases main street investors should avoid IPOs after they start trading. Just remember, history is against you when buying stocks shortly after they have gone public." On the other hand, stocks can become great bargains a few years after first being listed, says Rothery. "Very often IPOs crater when initial lofty expectations are not met. Provided that these broken IPOs have real businesses with decent fundamentals, they can represent great value."

David McEwen can be reached by email here.

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