Don’t fall for the IPO hype

Early buyers of King Digital are nursing a headache

When I was a young fund manager, having a box of pins in your drawer made you a very popular person. The 1980s was a golden period for privatisations and other IPOs (initial public offerings). In those days, you filled in the IPO application form and pinned – not stapled – your cheque to it. You had to use a pin.

We were in a long bull market and ‘stagging’ new issues was an exciting and profitable strategy. The ‘stag’ sells the newly floated shares immediately, taking an occasional loss, but more often a decent profit. Back then, there was always a public allocation of shares in an IPO and government privatisations in particular provided a near-certain profit.

IPO activity depends on the health of the stock market. And judging from current trends, I’d say the market is in decent shape at the moment.

However, I wonder how much of your investing time and effort should be devoted to new issues? There are 2,442 companies already listed on the UK stock market to choose from. So, why spend all your time focusing on a particular stock just because it’s being listed?

The market has IPO fever

Of course, IPOs can be a good way of taking the market’s temperature. If the market’s buoyant, there will be demand for new stories and opportunities. Equally, when valuations are good, owners are tempted to float their businesses. And the growth in private equity as a form of financing means there’s a ready supply of new companies as financial owners seek their exit. If the market is strong enough, the taps will be turned on.

Last year saw 105 companies come to the London market, which was the best number since the pre-crisis year of 2007. They weren’t all Aim tiddlers either. Forty percent were main market floats, including Royal Mail, which at £1.7bn was the largest European new issue of the year.

This trend seems to be continuing. Big names listing just in the retail sector during the last couple of months include Pets at Home, Poundland, AO World and Boohoo.com. It’s shaping up to be another strong year, which I take as an endorsement of the market’s well-being.

The time to worry is when the quality of new companies starts to fall and the market happily pays up for flaky businesses. I don’t think we’re at that stage yet.

Some of these IPOs have done well, others less so. Royal Mail kept up the tradition of the under-priced UK privatisation, and is currently trading around 70% above its October launch price. Of the more recent floats, Poundland (up 26%) is proving more of a bargain than Pets At Home (down 2%).

However, things have changed since the days of pinning your cheque on the application form and it’s hard to see why we should expect to find under-priced gems among the IPOs.



Sellers set the conditions that benefit them the most

By the time you hear about an IPO, so has everyone else. These are stories which have been hawked around by every fund manager on the planet. There will have been extensive management and analyst marketing roadshows. All the papers and financial media will have written them up. It’s part of the sale process to create an element of hype and excitement.

However, the ultimate reason for this overkill is the scale of fees involved in floating a company nowadays. It’s typical for them to be around a whopping 6% of the deal’s value. It’s hardly surprising that all a broker wants to talk about during the offer period is the IPO his firm is handling – it’s what pays his wages!

Any juicy premium to the offer price will only be there, because the seller is happy for that to be the case. If the seller is the UK government and the public (also known as voters) is receiving an allocation, then we can confidently expect a short-term profit.

If the seller is retaining a stake, then it’s in their interests to make sure the aftermarket is healthy and the price goes up. Management also want investors to see their company as a good stock; so a premium is nice from their perspective.

But if the vendors want to maximise their proceeds, then that’s exactly what they’ll do. And occasionally the sales hype leads to IPO investors getting carried away like drunken sailors.

Last week’s buyers of King Digital, maker of the game Candy Crush Saga, are nursing a quick 20% loss after its New York Stock Exchange float.

Fellow Nasdaq-listed Facebook fell by 50% in the first few months after its aggressively-priced float. The shares have done very well recently; but they took a long time to shake off the stigma of the botched IPO.

Don’t get ‘candy crushed’

The fact is the cards are stacked against you in an IPO. The vendor knows far more about the value of the company being floated than you do. And the extensive marketing effort means you won’t have an edge on your fellow investors – everyone will have considered the deal and has had the same information.

But thankfully, you’ve got other options. Many of the 2,442 stocks that are already listed will be mispriced. That’s because they are being offered for sale by existing shareholders who might be selling through boredom, or just to raise some cash. They don’t necessarily have in-depth knowledge on the company; but by doing some research we can gain an advantage.

We also have a lot of history to go on in terms of share price action, trading results, valuation ranges. I think we can make far better quality decisions in the secondary market than we are able to when looking at an IPO.

So, unless it’s the government offering you a gift horse, I’d advise patience and selectivity with IPOs. There will be some winners out there, but it makes sense to take your time in sorting the wheat from the chaff. Next time, I’ll look at a recent IPO to see how quickly things can go wrong.

This article is taken from our FREE penny share investment email Penny Sleuth.
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