As a fund manager, I’ve invested in a large number of IPOs over my career – some of which went on to generate strong returns for many years and others where I sold out in despair after a period of underperformance.
IPOs have always held a particular fascination for investors, and to many they represent the chance to invest in the next generation of exciting growth opportunities. But as experienced investors know, there is a dark side to these investments – not least a reputation for underperformance over time.
When it comes to IPOs, being selective is crucial to achieving a good result. As Warren Buffett said: ‘You don’t have to swing at everything – you can wait for your pitch.’
The Secret Guide To IPOs
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1. Understand the business
An IPO is like a shotgun wedding – the investor only has a limited time to get to know the business before making a commitment. This is a very different situation to a quoted company, where the investor enjoys a long period of courtship before deciding to invest. An IPO requires a much more intensive research effort over a short period of time, often with less information than is available for a listed company. However, the information is there for those who are prepared to put in the work.
A detailed study of the Prospectus will provide most of the information needed – in particular the MD&A (Management Discussion and Analysis) and the Financials (see below). Beyond that, a study of listed competitors will yield valuable insights into the industry as a whole.
2. Exercise caution around ‘hot issues’
Too many investors will buy into an IPO simply because it seems ‘hot’ or has a topical ‘investment story’ attached to it. The problem with hot issues is twofold – one, they tend to get overpriced; and two, they tend to attract fast money that runs for the exit at the first sign of trouble. Sometimes these IPOs will get heavily over-subscribed, leading to a strong rally in the first few days (often led by investors who didn’t get their full allocation buying in). But as the initial excitement fades and reality settles in, the initial gain is followed by a long period of underperformance.
In other cases, where the IPO has been priced way too high, and where there is too much fast money in the book, the stock might even see an immediate drop on the first day of trading. It’s not a case of ignoring hot IPOs, but you should certainly understand your own reasons for investing.
You are neither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right.
3. Study the financials
The IPO Prospectus includes plenty of detailed financial information that will help inform your view of the company. In my experience, investors spend too much time focusing on the earnings forecasts of sell-side analysts (which almost always turn out to be far too bullish anyway) and too little time on the reported numbers.
A thorough study of the financials will help you understand how the business performs over the cycle as well as providing evidence of management’s competence (see Point 5). In particular, metrics such as revenue growth, margins and ROIC (and a comparison of these metrics to peers) will help frame your expectations of the company’s prospects.
We can make excellent investment decisions on the basis of present observations, with no need to make guesses about the future.
4. Risk awareness
The section of the Prospectus that deals with risk factors usually runs to several pages and is padded with a host of generic risks, often with little apparent relevance to the investment. Nevertheless, it’s important to read carefully because hidden within this section will be a number of key weaknesses and threats that actually are highly relevant. You will want to be satisfied that the management understands these risks, and has an adequate strategy for addressing them.
While sell-side analysts like to focus on the upside, as an investor you need to ensure that you’ve spent an equal amount of time thinking about the downside.
The problem is that with so much attention being paid to the upside, it is easy to lose sight of the risk.
5. Look for a great management team
When analysing a listed company, the track record of the management team is often laid out on the table for all to see. When it comes to an IPO that clarity is lacking, so you need to dig deeper by asking questions. How long has the management team been at the helm of the company and what has it achieved during that time? If a board member came in from elsewhere, what was their role and what did they achieve there? You also need to assess the management as an entire team – do they collectively provide the skill set needed for this next stage of development? These are all important questions to answer before putting your faith in management.
I’m not interested in meeting management today… I’m more interested in finding out how a person has behaved in the past.
6. Understand the reason for listing
IPOs are often a mix of a ‘primary offering’ (raising of new capital) and a ‘secondary offering’ (where existing shareholders are selling into the market). Where an offer is mostly primary, then what will the additional cash be used for? In the case of a high-growth company the cash may be needed for organic expansion. But where the company has less obvious needs for cash, or where it is being used simply to pay down debt, investors need to understand more. Is a company is simply adding to its war chest so that it can become a bigger company through aggressive acquisition?
Where an offer is mostly secondary, it will typically involve a private equity or venture capital firm selling down their stake. Here you need to understand the reasons for exiting and the extent to which they are reducing their position. Investors usually like to see that the original shareholders are maintaining a significant stake in the company for a reasonable period of time. Study the terms of the ‘lock up’ to ensure that such an arrangement is in place and is adequate.
In my opinion, a lack of discipline on price is one of the most common traps that investors fall into. Because investors do so much work before the pricing is set, they risk becoming emotionally attached to an investment and don’t want to see their work ‘go to waste’. This is why it’s important to have a firm idea of what you’re prepared to pay and not go beyond that. A comparison of multiples to listed peers is a good place to start – you should be looking for the price to reflect an attractive ‘IPO discount’. If the multiple is more expensive versus listed peers, then there needs to be a strong reason why this is the case.
8. Embrace volatility
IPOs are naturally volatile beasts. It amazes me how, in the months after an IPO, a stock remains highly volatile despite the release of no new information. If you understand the company well you can use this to your advantage to top up on your position at attractive prices (particularly if you didn’t get your full allocation).
Volatility is a long-term investor’s best friend.
In many ways an investment in an IPO is no different from any other investment – it requires thorough analysis, sound judgment and discipline. While there are a number of specific risks and pitfalls to consider, a good IPO can offer the chance to buy into a quality company at a discount to the secondary market price.
Where a company has the right business model and the right management team, access to additional capital from public markets can provide the catalyst needed to accelerate the company’s development. In these cases the relationship between the investor and the company is mutually beneficial, leading to a long and happy marriage.
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