Demand for equities is high right now – but supply is rising to meet it

Investors can’t get enough of equities. And with 2021 set to be a record year for stockmarket listings, there will be plenty available. But not everything is worth buying, says John Stepek. Here’s what you need to look out for.

Whatever else Richard Branson is – and I’m sure there’s a range of colourful views you could share with me on that matter – you can’t deny that he’s a showman.

The Virgin founder went into space (or near space, depending on how pedantic or critical you want to be) at the weekend, pipping Amazon founder Jeff Bezos to the post.

You’d think such a triumph would have been welcomed by the Virgin Galactic shareholders. And yet the share price slid by nearly 20% yesterday.

Turns out there was a very good reason for that – and it points to a wider point that investors need to bear in mind.

Bezos vs Branson is a great marketing stunt

Richard Branson managed to beat Jeff Bezos into near-orbit at the weekend. Yet shares in his space tourism company Virgin Galactic slid by 17% on Monday.

Why? Because the company used the opportunity to file for permission to flog another $500m worth of shares to the market.

Those might well be snapped up – particularly if the company can keep repeating the trips and establish a big enough pool of buyers at $300,000 per ticket (the hoped-for rate).

But it’s a valuable reminder that supply matters. And this is pertinent, because an awful lot of supply of equities in general is going to be hitting the market this year.

In fact, it looks like 2021 will “be the biggest year for traditional IPOs” on record, notes the Lex column in the FT. In other words, even if you ignore the “Spac” boom (the US craze for cash shells, which is how Virgin Galactic went public – more on those here), it’s still been a banner year for privately-owned companies going public in the US.

And the supply is only likely to get greater from here.

According to the Wall Street Journal, in the first half of 2021, 105 private equity-backed companies went public in the US. That’s triple the numbers seen in the whole of 2019, and it’s already surpassed the 89 seen in the whole of last year.

There have been a lot of “top of the market” moments in this particular cycle and none of them have actually indicated the “top of the market”. But it is entirely true to say that buoyant IPO activity (merger and acquisition too) is something you see nearer tops rather than bottoms.

The reason for that is simple: it’s basic supply and demand. After a crash, no one wants to buy the stocks that are already on the market let alone shares in new companies, so it’s hard to get IPOs away.

When the market is at record levels (like this one), it’s a sign that demand for equities is high, so it’s easy to feed new supply into that market.

Private equity companies currently have plenty of that. And there are some good reasons why they might want to offload some of it.

Be wary when insiders are selling out

When companies go public, it’s worth understanding why. You have a situation where a group of insiders – whose knowledge of the company and its markets should be better than anyone else’s – are looking to sell. So why are they looking to sell now? What do they know that you don’t?

Why are private equity sellers lining up now? In this context, you can think of private equity in terms of the housing market, with private equity companies as property developers.

Some property developers buy a site or a shell with potential. This is potential that only they can unlock, because they have vision, contacts, and access to resources that other people simply don’t have. They work hard, unlock the potential, and add a huge amount of value in the process.

Other property developers buy a place, slap a load of magnolia paint on the walls, magnolia carpets on the floors, then flip it to a naive first-time buyer who is just relieved to find a flat without an avocado bathroom suite.

One type of developer should be able to turn a profit in any environment. But both types of developer – good and bad – will do well in an environment in which mortgage rates and the cost of borrowing are falling, because that in itself will drive the price of even an unimproved property higher.

This is one reason that TV in the 2000s was full of “home makeover” shows. A visibly frustrated Sarah Beeny would have her sage advice utterly ignored by a couple of amateur property tycoons, who would still turn a profit by the end of the programme, simply because mortgages had become even cheaper in the intervening six months.

What happens when the interest rate cycle turns or prices look peaky – or both? The “good” developer will be less concerned. In effect, they’ve made a value investment. It’s about taking a dud asset and making it better. They should be able to turn a profit either way.

But the “bad” developer will be keen to get out fast. In effect, they are pursuing a momentum strategy. If conditions change then chances are they’ll struggle to get rid of their purchases.

You can see this in action right now.

As the Lex column notes, only about a quarter of the companies that have gone public this year made a profit in their last fiscal year. That’s a rough and ready measure – some unprofitable companies come very good eventually. But as an indicator that there’s a ready supply of “greater fools” out there to receive whatever insiders throw at them, it’s pretty convincing.

Notes Lex: “For some, watching people pour money into unprofitable companies evokes memories of the dotcom bubble. But as long as rates remain low and yield remains scarce, investors will keep going to the IPO trough.”

But of course, this is the big question right now. Given that inflation is the fear du jour, will rates remain low? I’m guessing that the rush to IPO is itself a hint that maybe the sellers (the private equity players) are concerned that this window of opportunity may not remain wide open for long.

If you can’t beat ‘em, join ‘em

Now, as an individual investor, this need not affect your asset allocation or your overall strategy. The US market may look overheated, but it has done for a while, and there’s no point in trying to second-guess when that might change.

However, it is useful to remember a few points arising from this.

Firstly, when IPOs are plentiful and popular, chances are a lot of them are poor quality because this is an easy market to sell into. So if you are someone who invests in individual stocks or plays IPOs, you should be even more sceptical than usual at this stage in the cycle. Insiders tend to be better informed. If they’re selling now, why are you buying?

Secondly, private-equity firms still need to find opportunities. After all, all that exit money and all that new money from pension funds keen to raise their allocations to “illiquid” strategies has to go somewhere.

The good news is that there are still some inexpensive “value” investments that private equity firms are alighting on. They’re mostly in the UK right now. Fund managers are complaining that they’re getting these companies too cheap. But if that’s the case, then maybe, as Merryn suggested recently, you should join them?

Subscribe now to get your first six issues free.

Recommended

State pension errors – why tens of thousands of mothers could be missing out on millions in state pension payments
State pensions

State pension errors – why tens of thousands of mothers could be missing out on millions in state pension payments

LCP launches Mothers Missing Millions campaign amid DWP state pension errors.
3 Dec 2022
The top funds to invest in now
Funds

The top funds to invest in now

As market volatility continues, here are the top funds, stocks and investment trusts investors are putting their money into, according to one investme…
2 Dec 2022
The best places to live in the UK – and how much they will cost you
House prices

The best places to live in the UK – and how much they will cost you

Thinking of moving? Here are the best places to live in the UK and how much they will cost if you are buying.
2 Dec 2022
The pros and cons of smart meters – should you switch?
Personal finance

The pros and cons of smart meters – should you switch?

A smart meter can help you keep tabs on your energy usage, but is it better than a regular meter? We take a look at smart meters vs regular meters.
2 Dec 2022

Most Popular

Fan heater vs oil heater – which is cheaper?
Personal finance

Fan heater vs oil heater – which is cheaper?

Sales of portable heaters have soared, as households look to cut their energy costs. But which is better: a fan heater or an oil heater? We put them t…
21 Nov 2022
Stock market crash? This time it’s (slightly) different
Stockmarkets

Stock market crash? This time it’s (slightly) different

The bears expecting a stock market crash have got it wrong, says Max King.
30 Nov 2022
Is it cheaper to leave the heating on low all day?
Personal finance

Is it cheaper to leave the heating on low all day?

The weather is getting colder and energy bills are rising, but is it really cheaper to leave the heating on low all day or should you only turn it on …
1 Dec 2022