OPINION: The initial public offer window is wide open. After three years of rising share prices, a flood of private companies are looking to list on the sharemarket.
Before people rush out and buy, however, they might want to consider some of the dos and don'ts when perusing the first offer to the public of shares in the soon-to-be-listed company.
When buying a company at IPO it is important to remember that IPOs are unlike most secondary market transactions, where it is generally assumed that both the buyer and the seller have the same information available to them.
This is not the case at IPO. The seller has far more information.
In his famous 1970 paper, The Market for Lemons: Quality Uncertainty and the Market Mechanism, economist George Akerlof showed that situations where the seller knows more than the buyer might result in mutually beneficial transactions failing to happen.
Akerlof uses the example of used cars. The seller is far more likely to know if the car is of good quality or if it's not - if it's a "lemon".
This asymmetry of information means that while a seller won't sell a good-quality used car for less than it's worth, a buyer won't buy at more than the average price, fearing that they're purchasing a lemon.
A situation develops where there's no market for good used cars.
This perhaps explains why research indicates that IPO buyers are on average losers. Of course, not all are losers, but I'm looking at IPOs from the perspective of a long-term investor.
Many participants in IPOs do invest for the stag - buying a security with no knowledge of the company or its intrinsic value and selling straight after listing on the basis that a greater fool than they will buy it.
While there is research that shows you can earn excess short-term returns on the average IPO stag, it does not account for the fact that you will probably be heavily scaled in the popular IPOs. The effect of scaling is that it forces you to bet big on the losers and small on the winners.
Research by Ibbotson (1975), Ritter (1991), Loughran and Ritter (1995), and Levis (1993) concluded that investing in IPOs was a poor long-term investment relative to their listed peers.
While short-term gains might be made, these are quickly eroded by poor medium-term performance.
You can see a chart illustrating the long-term performance of 1526 IPOs from 1975 to 1984 here: http:// www.kellogg.northwestern.edu/researchcomputing/workshops/papers/ritter-jf1991.pdf
The conclusion must be that when the IPO window is wide open, expect plenty of lemons.
Here are some red flags for lemons: private equity sellers, roll-ups, high debt, no profit.
Individually, these are not necessarily showstoppers, just red flags.
There are some very good private equity companies that build good businesses. However, it is their job to maximise value for their investors, not the new shareholders arriving at IPO.
Roll-ups are business that have been put together recently for the purpose of listing. The information asymmetry here is even worse than for the normal IPO. Often the motive for listing is questionable.
High debt levels are a red flag for any listed company, but there is no excuse for it at IPO. It is a sign that there may have been an attempt to maximise value extraction before IPO.
Another wealth-extracting trick is for the company to sell and lease back its assets and pay a large dividend before IPO.
The issue with companies that have never earned a profit is that they have not yet been properly tested.
It is easy to sell a product or service if you price it too cheaply.
Also, without a current profit number to benchmark a value from, it is far too easy to benchmark it from some larger potential, blue-sky profit number that it might earn one day.
But this is not to say that I think you should never invest at IPO time. There are sometimes some fantastic companies offered.
You just need to do your homework and research the company at least as thoroughly as you might do when buying a used car. Actually, a bit more care is required than when buying a used car.
It is the opinion of the Castle Point team that the best investments to be made in the sharemarket are in those companies of the highest quality and/or the cheapest price.
It is highly unlikely that a company will be sold cheaply at IPO, so the focus should be on those companies of the highest quality.
An indicator of quality might be a stable and appropriately incentivised management team, preferably having been employed by the company for over five years and retaining a material ownership stake in the business.
Another is a track record of sound margins, while past growth with reasonable potential for more is a possible green flag.
You definitely want moderate to low levels of debt for reasons I mentioned earlier.
The price you will pay for these companies is unlikely to make them cheap, but held for a long time, you should see reasonable returns.
Richard Stubbs is co-founder and director of the boutique funds management team at Castle Point Funds.
Disclosure statement: Castle Point has participated in past IPOs and is likely to participate in future IPOs.