In 1986 I worked for British Gas, helping to manage their huge pension fund. It was a big year for the company – the year it finally floated on the stock market. And that was a fascinating thing to observe from inside the company.
The employees were excited, of course – everyone hoped to get a preferential allocation of shares in the new PLC. This was Mrs Thatcher’s heyday. Her government privatised Amersham International, then British Telecom, with British Gas following in late 1986. And private investors were encouraged to own shares, taking a stake in the nation’s economic success (remember the famous “Sid” advertising campaign). Of course the best way to guarantee public participation was to sell the shares cheaply and provide a quick, easy profit.
You’ll be bombarded with publicity about the Royal Mail share flotation in the next few weeks. A privatisation adds a political dimension to the whole thing, which would already have been a bit of a media frenzy. Hype is part and parcel of initial public offerings (IPOs). It’s one of the things that mark them out as a sort of special case when it comes to investing. But before you’re tempted to get in on the Royal Mail deal, I want to tell you a few truths about investing in IPOs.
They know something you don’t
That walk down memory lane might lead you to think that I’m a fan of investing in new issues, or IPOs. Well, I’m not. Let me explain why.
The UK stock market is home to a couple of thousand listed companies. Most have been filing accounts and announcing results for years – decades, in many cases. We have a huge amount of information about them. We also know how their businesses and share prices have performed over many bull and bear markets.
That gives us a very good idea of their value. The stock exchange is constantly matching many buyers and sellers, giving us a fair open-market price in real time. Furthermore, have no reason to believe that the person selling the shares that I’m buying knows anything more than I do about the company.
Compare that with the knowledge we have about an IPO. The prospectus will only show us three years’ worth of numbers. And the company might have been dressed up for sale by flattering these; for example by delaying expenditure to boost short term profits. Disinterested analysis is hard to find because the company being floated usually signs up most of the City to act as advisers.
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But the most dangerous part of the process for an investor is pricing. The seller of shares in an IPO is the existing owner of a private company. They have far more information about its true value than you as a prospective investor can hope to have. It is in their interests to talk up the price, supported by their investment banks and brokers who are massively incentivised to do the deal.
Have you noticed that if there is a big IPO happening, it’s impossible to get a broker to talk about anything else? Why? Because their fees for selling the deal dwarf fees they earn from regular share trading.
Short term thinking
My worst experience of IPOs was my time in the Russian market. Given their traumatic history, Russians tend to have a “short term” view of life. So for the seller of a company, maximising the IPO price is usually the priority. The original owners will normally retain a majority stake; so they don’t really care about building a partnership with their new co-owners post IPO. This can even extend to privatisations. Take major state controlled bank VTB as an example. Shares were offered to the market at $10.50 in 2007. They never managed to sustain a meaningful premium, and the current price is just $2.70. The Kremlin has even been sufficiently embarrassed into reimbursing small shareholders!
To be fair, most companies in Western markets are much more even handed than this when managing the IPO. They want a friendly relationship with their new shareholders. For them, it makes sense to strike an offering price that leaves some near-term upside. The next important thing for them to do is not disappoint when it comes to the first sets of results. That way they can build a loyal shareholder base, get a decent rating on their shares, and then be able to use the markets to raise fresh equity and do deals.
My preferred approach is to wait and see. It’s so easy to be sucked into the hoopla and hype surrounding an IPO despite the odds often being stacked against you. It’s often better to buy your shares ‘second hand’ at a time and price of your choosing. We will have to see whether the upcoming Royal Mail flotation is priced like a 1980s-style privatisation. As with any investment, we must do our research and make up our own minds. But beware – when it comes to IPOs, the playing field is less level than usual.
• This article is taken from our free twice-weekly small-cap investment email, The Penny Sleuth. Sign up to The Penny Sleuth here.
Information in The Penny Sleuth is for general information only and is not intended to be relied upon by individual readers in making (or not making) specific investment decisions. The Penny Sleuth is an unregulated product published by Fleet Street Publications Ltd. Fleet Street Publications Ltd is authorised and regulated by the Financial Conduct Authority. FCA No 115234. http://www.fsa.gov.uk/register/home.do
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