Investors get excited by IPOs on the stock exchange. But new flotations tend to disappoint over time. You should back the old-timers, says Richard Beddard.
So far, 2017 has been disappointing for fans of flotations. Fewer new companies listed on the London Stock Exchange in the first three months of this year than in any of the previous four years, says Reuters. But while a vibrant stockmarket matters for the economy, the dearth of new issues may be better news for your portfolio than you think. Although the share price of a new issue often enjoys a tidy bump on its first day of trading, on average investors who hold the shares for longer earn comparatively poor returns. Between 1980 and 2014, US investors who bought into initial public offerings (IPOs) at the issue price made 18% less than the market over the following three years, according to Jay Ritter of the University of Florida’s Warrington College of Business. It’s a similar story in the UK. Professors Elroy Dimson and Paul Marsh of the London Business School found that between 2000 and 2014 investors who held new issues for two years would have underperformed the market by more than 9%.
Why do IPOs disappoint like this? Typically, these are shares in young companies in fashionable industries that are experiencing rapid growth. Investors are willing to pay more for these traits than subsequent performance justifies – a tendency we might call “the triumph of hope over experience”. Hope hits new heights during stockmarket bubbles – such as the dotcom boom of the late 1990s – and enthusiasm for new issues often becomes contagious. For brief periods, they can produce explosive returns and, of course, a handful become the Googles or Amazons of the future, which is why investors continue to chase the dream.
Generally, though, they are sub-par investments, even over long periods. While the woeful performance of new issues in the years immediately after flotation is common (if unheeded) knowledge, it is, perhaps, less widely understood just how long the deleterious IPO effect lasts. Dimson, Marsh and Mike Staunton (another professor at the London Business School) studied the long-term returns of UK IPOs between 1980 and 2014 to determine the effect of “seasoning” – the length of time that a company has been listed – on returns. They split the market into four pots: companies listed for three years or less; those listed for four to seven years; for eight to 20 years; and for more than 20 years. They then measured the total return (ie, including reinvested dividends) from shares with the requisite amount of seasoning at the start of each year, recalculating the pots annually to ensure that they still held shares that had been listed for the correct duration (so each year, for example, companies listed for more than three years would move from the least “seasoned” basket to the next one up, and be replaced by fresh IPOs).
Thirty-five years of returns published in the Credit Suisse Global Investment Returns Yearbook in 2015 showed that £1 invested in the least seasoned stocks (those listed for three years or less) grew to £20. That may sound like a reasonable return, until you consider the performance of the other pots. The returns increased with the amount of seasoning; £33 for companies listed for between four and seven years, £49 for eight to 20 years, and £61 for the most seasoned. The professors concluded: “At the stock level, old clearly beats new.”
Five seasoned companies that should prosper
One reason that new issues make poor investments is that the previous owners of the shares – usually the founders – sell up at propitious moments. The beauty of a business with a short track record is that it gives less well-informed investors a blank canvas on which to paint a rosy picture of the future. However, mindful long-term investors will prefer being able to look back to see how a company has performed through thick and thin. While a new issue may not even have been in business the last time we experienced a recession, the information is readily available in the annual reports of established companies. Ironically, the best-performing shares are often the ones we can learn most about.
Float date: 1939
Market capitalisation: £115bn
Debt-adjusted price/earnings (p/e) ratio: 26
Unilever was born of the 1929 merger of Lever Brothers (founded in 1885 to manufacture Sunlight Soap) and Margarine Unie, a Dutch margarine maker whose origins went back to 1872. Since then, the group has developed and bought major food and household goods brands, including Marmite, while growing global manufacturing, marketing and distribution capabilities. It’s survived depression, war, nationalisation in the Soviet Union and China, diversification and rationalisation. And it’s grown: in the past financial year, annual sales hit €52bn.
If ever there was an example of success leading to more success, it’s Unilever. Revenue growth has been tepid in recent years because economic growth in the developing world – where it earns the most revenue – has slowed. Yet Unilever remains highly profitable. Over the past decade, return on capital has averaged 26%, dipping only to 23% during the credit crunch in 2009. Back then, Paul Polman, the company’s chief executive, joined with a promise to double revenue, and halve Unilever’s environmental footprint. The remarkable reliability of big brands such as Lynx, Wall’s, Dove, Hellmann’s, Knorr and Surf, as well as Unilever’s adaptability, its acquisition of promising new brands and ruthless disposal of more mature ones, attracts investors, despite the punchy valuation.
Float date: 1942
Market cap: £6bn
Debt-adjusted p/e: 18
Johnson Matthey has had an illustrious yet at times inglorious history. In the 19th century, it was chief gold assayer and refiner for the Bank of England. It used its expertise in processing platinum to manufacture the kilogram reference standard held at the International Bureau of Weights and Measures, but the company had to be rescued by the Bank of England in 1985, when its banking arm collapsed.
Today it is a major manufacturer of the catalysts used to cut emissions from vehicles and machines, refining fuels, and fabricating products from precious metals. The company also processes precious metals, supplies fine chemicals and provides battery and fuel cell technology. Having endured its own financial crisis in the 1980s, it was relatively untroubled during the financial crisis of 2008 and has emerged with its chemical expertise intact and ready to apply to 21st-century problems.
Float date: 1948
Market cap.: £6bn
Debt-adjusted p/e: 11
During the financial year ending in January 2017, the fashion chain Next saw its return on capital shrink to 23%. That was the first time its profitability had fallen since 2009. Back then, during a recession, its return on capital came in at 18%, just 4 percentage points below its 22% average over the past decade.
These statistics show that Next has been an outstandingly profitable retailer. But traders have taken flight, seeing perhaps the start of a trend. Next shrunk slightly in the year to January, and, it warns, revenue and profit is likely to fall further in 2018. The group blames a temporary shift in consumer spending patterns from buying things to buying “experiences” (such as eating out). Tightened purse strings due to low wage growth and the higher cost of imported fashion, due to the weakened pound, have also hit profitability.
But none of these problems are likely to damage the company permanently, and while sales have been leeching out to the internet for some time Next has captured them through Next Directory, a mail-order business that now earns more profit than the stores. Next went public in 1948, but the business as we now know it, a fashion and homeware retail chain and mail order firm, was born in the 1980s. Under Lord Wolfson, chief executive since 2001, Next has prospered by focusing on stylish mainstream design, efficient sourcing and distribution and good customer service. It has avoided wasting shareholders’ cash on costly acquisitions or unprofitable expansion, instead returning it to them via special dividends and share buybacks.
Float date: 1973
Market cap: £330m
Debt-adjusted p/e: 23
Vp started life as Vibratory Roller and Plant Hire (Northern) in 1954. It was founded by its current chairman, former chief executive and majority shareholder Jeremy Pilkington. Construction businesses often hand rented equipment back when recessions strike, but Vp has found some stability in plant hire. At first it did well out of the construction of the M1 motorway. Its first foray into specialist equipment came in 1975 with the acquisition of Airpac, which supplies high-capacity air compressors. Then it moved into hydraulic supports for trenches and other groundworks; railway plant and services; rough-terrain forklift trucks; tool hire; and temporary roadways, walkways and bridges. A recent acquisition supplies test and measurement tools.
Vp’s businesses form long-term partnerships with customers across diverse industries whose economic cycles often do not coincide. Infrastructure projects follow regulatory cycles; construction and housebuilding follow the business cycle; and Vp’s oil and gas business Airpac Bukom depends on investment in oil exploration. While many customers scaled back their activities during the financial crisis, Vp stayed profitable. Over the past ten years return on capital has averaged 16%.
Float date: 1988
Market cap: £103m
Debt-adjusted p/e: 16
Portmeirion listed in 1988, but its most popular brand of tableware – Portmeirion Botanic Garden – was designed in 1972. Its oldest brand, Spode Blue Italian, dates back to 1816 and was acquired (with Spode) out of administration in 2009. Other brands include Royal Worcester (acquired in 2009), the coaster and placemat brand Pimpernel, and Wax Lyrical, which makes home fragrances. Portmeirion acquired the latter last year, but despite adding substantially to profit it failed to mask a contraction in overall earnings for the first time since the credit crunch, when profitability dipped into single figures.
The company is being held back in South Korea – where Stoke-on-Trent-manufactured Botanic Garden had been growing in popularity for more than a decade – and in India, where sales surged in 2015, only to wash away as quickly as they had arrived. The company believes these declines are temporary, the result of weak economic growth in South Korea and mistakes in India, which it is addressing with its distributors. It’s also wary because of political developments in its two main markets, the UK and the US. Like the other companies in this selection, though, brand power has made Portmeirion a strong performer. It has earned an average return on capital of 16% over the past decade.
The ten most seasoned companies listed in London
|Daily Mail & General Trust||11-Nov-32|
|Associated British Engineering||05-Nov-37|
|Tate & Lyle||09-Dec-38|
|Inch Kenneth Kajang Rubber||29-May-40|
Older companies may make better investments in general, but as with any large dataset, look within it and you will find strong contrasts and plenty of individual companies that don’t fit the rule of thumb. Only four of the ten companies that have been listed for longest in London (see table) sit in the largest 100 by market capitalisation, for example – one indicator of long-term success.
Unilever, ranked third in the FTSE 100 (after Shell, the oil company, and the banking giant HSBC), has grown into a behemoth valued at £115bn. The engineering conglomerate Smiths Group, housebuilder Taylor Wimpey and Johnson Matthey are also in the largest tier of listed companies. The sugar producer Tate & Lyle and Daily Mail & General Trust, the media group that owns the eponymous newspaper, are multibillion-pound enterprises that don’t sit too far outside it.
The other four survivors, all of which listed before the end of World War II, are notable for their relatively small size. Associated British Engineering is one of the smallest London-listed companies, with a market capitalisation of just £0.8m.
ABE’s recent annual and half-year reports serve as a salutary lesson to any investor who thinks that a long stockmarket history might guarantee investment success. The company’s results tell a grim tale of financial losses, pension deficits, the loss of long-serving employees and disputes with customers over unprecedented numbers of warranty claims as ABE’s subsidiaries – which maintain and service diesel engines – struggle to cope with the downturn in the oil industry.