Why you should do your homework before investing in an IPO

Posted by News Express | 13 January 2020 | 933 times

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Initial public offerings (IPOs) have a way of grabbing our attention. As an investment analyst, the phone rings off the hook with “well-meaning” bankers providing updates on the latest hot listing, and diaries fill up with meeting requests. Post listing, it’s amazing how these roadshows dry up.

Some can be good investments, but most often the risks outweigh the reward. There are many reasons why the barrier to investing in an IPO should be higher than simply purchasing shares on the secondary market, but there are a few key lessons we have learnt from 26 years of investing around the globe.

IPOs involve insiders selling shares to outside investors. Typically, these insiders are intimately involved in the business, either through direct management or via a seat on the board. They know the business better than anyone else … and they are choosing to sell.

To make matters worse, they set the price and date of the listing. Unlike purchasing shares on an exchange, where both buyers and sellers have access to similar information, the price is market-determined and timing is up to the buyer; with IPOs, the insiders have a clear information advantage over potential buyers. It’s like playing poker with someone who has already seen all the cards in the deck.

Insiders know exactly when the IPO will occur, with many months’ notice. It is unsurprising, then, that management teams do their very best to ensure that everything looks great by the time the IPO date arrives.

Every day stock exchanges around the world facilitate trades in the thousands of companies listed globally. All but a handful of trades occur with little fanfare, marketing or hype. The story of IPOs could not be more different. A string of analysts, advisers, brokers, bankers and company representatives are readily available to walk you through the investment case, five-year plans and reasons this is too good an opportunity to be missed.

The level of noise surrounding an IPO is deafening, but just because it’s front of mind doesn’t mean it’s a good investment. In the global frontier markets universe, Jumia, the so-called “Amazon of Africa”, was the subject of similar hype. This was especially so after it listed at $14.50 a share and the share price quickly moved up to almost $50 in a matter of weeks, before giving back all the gains. Jumia now trades below its listing price.

By reading and analysing listed companies’ publicly available financial statements through the years, an investor can observe how the business performs through the economic cycle; in good times and in bad. They can observe the culture of the business, how capital is allocated and how management teams treat shareholders and other stakeholders. While anyone operating in financial markets knows past performance is no guarantee of future success, the past does provide valuable insights into a business.

At Coronation, we will regularly analyse 10 or even 20 years of a company’s operating history and financial performance as we evaluate investment opportunities. IPOs do not afford the same opportunity as historic financials for the past three years are typically all that is disclosed. Optimising the financials over a fairly short period of time is not difficult — capex can be delayed, sales pushed onto distributors and discretionary expenditure postponed. As a result, it’s tough to really know what you are buying when it comes to IPOs.

While the issues discussed are significant, they are not insurmountable, and every so often an opportunity crosses our desk that has a sufficient margin of safety to warrant a position in our portfolios (even after adjusting for the concerns raised here). The important thing to understand is how the very nature of an IPO works against the buyer and, in response, to increase the required return needed to invest.

IPOs are simply another investment opportunity that may or may not be attractive. The idiosyncratic risks of the listing process, though, do require a little bit of extra care and thought. (Business Day SA)



Source: News Express

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