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11 tips on IPO investing

Photo of Tony Featherstone By Tony Featherstone

min read

Here is an enduring investment truth: the best initial public offerings (IPOs) are usually the hardest to get stock in. Their offer can open and close quickly, with most stock reserved for institutional investors or clients of the sponsoring stockbroking firm.

The good news is these keenly sought IPOs can be bought in the secondary market after they list on ASX, when stock is readily available. The stock may or may not be as cheap as it was in the IPO, but it pays to follow sharemarket floats upon listing.

This has been a solid year for IPOs. Although down on last year’s record IPO market, $5.5 billion was raised through IPOs on ASX in the calendar year to September 30, 2015, ASX data shows. There were 67 IPOs in this period and several more in October, including the successful listing of Link Group, the year’s largest IPO.

Here are 11 tips with IPO investing:

1. Understand the risks
The IPO market can be a tremendous source of wealth creation. Think of Commonwealth Bank of Australia investors who bought stock in the first tranche of the float at an issue price of $5.40 in 1991. CBA traded at $77 in early October 2015.

IPOs can range from multi-billion-dollar privatisations, such as CBA, Telstra Corporation and Medibank Private, to a junior mining company that seeks to raise $4 million. But all IPOs have an added layer of risk because most have no history as a listed company. That extra risk needs to be factored into the valuation.

2. Get in the IPO loop
Prospective IPO investors can be frustrated when stock is hard to get or the IPO opens and closes in the blink. The ASX Upcoming Listings page has information on companies that have applied for official admission to ASX.

For information on companies that are proposing an IPO or are testing their offer with institutional investors, read the Street Talk column in the Australian Financial Review or the business pages of The Australian. Identify which broking firms are most active in the floats you prefer and consider opening an account with them and building a relationship.

3. Read the prospectus
Novice investors can be put off by IPO prospectuses, which sometime resemble mini telephone books. Granted, they are not the easiest document to read but it is well worth the effort. You will learn more about the company and its industry in the prospectus than in any other piece of corporate communication.

Read the IPO’s supplementary or replacement prospectuses if the Australian Securities and Investments Commission (ASIC) deems additional or revised information is required.

4. Do you understand the company?
As with any investment, if you don’t understand an IPO, don’t buy it. After reading the prospectus you should be able to form a view on how the company makes money, its industry position and the key drivers of its earnings.

For a pre-revenue company, such as a mining explorer or emerging technology company, you should understand the pathway towards commercialisation and the key risks.

5. Management
Few things tell you more about the quality of an IPO than its management. Assessing the executive team is especially important with smaller IPOs that rely heavily on a few key people to create long-term, sustainable wealth for shareholders.

Consider the executive team’s past achievements. Have they made money for previous shareholders? Are they experienced and well-regarded in their industry? Is there sufficient depth in the executive team or does it rely mostly on the CEO?

Most of all, read the executive remuneration policy outlined in the prospectus. Are management’s financial incentives appropriately aligned with shareholders? How does the CEO’s pay compare to others who run similar entities? Is too much of the CEO’s pay guaranteed through fixed payments, such as cash salary?

6. Skin in the game
In addition to executive pay levels, how much does the executive team have invested in the business? How many shares do they own? Is a large part of their pay delivered through long-term incentives, such as options plans? What targets must be achieved before options or other performance incentives are granted? Are their shares escrowed, thus cannot be sold for a certain period?

Some investors prefer CEOs who are strongly locked into the IPO through high share ownership or long-term pay incentives. They believe these CEOs think more like owner-managers. That’s not to say professional managers, who own fewer shares, cannot add great value to an IPO. But ask what the CEO loses if the IPO fails.

7. Board
Boards are sometime overlooked in IPO analysis. Most focus is on the CEO, but the board’s biggest task is to choose the right CEO, give them appropriate incentives and monitor their performance. A high-performing executive team usually starts with a good board.

Consider the strength of the IPO’s board. How experienced are its directors? Is there a good mix of skills? Do directors own shares in the IPO and if so, how many? How independent is the board from the executive team? High-quality boards typically do a lot of due diligence on an organisation before agreeing to govern it.

8. Where is the money going?
Some vendors use IPOs as an exit strategy to enable founding shareholders to sell all or part their shares. Others use the IPO to raise capital that is reinvested in the business and potentially quicken its growth.

Every company is different, but I prefer IPOs that reinvest all or most capital raised into the business. It means the founding shareholders have greater incentive to grow the organisation for the long term and better alignment of interests with new shareholders. Also, some newly listed companies struggle when the founders retire and new management takes over.

9. Capital structure
Understand what the IPO’s capital structure would look like if all options granted to executives or investors were exercised. Or what happens when restructured securities are available to be sold in a year or two after listing. And how much debt is involved?

Excessive share issuance can dilute existing shareholders and weigh on the organisation’s earnings per share and return on equity. It may not be an issue if the executive team has to meet tough return hurdles to achieve their performance-related shares or options, but always form a view on the capital structure.

10. Follow the aftermarket
Investors can give up on an IPO when they cannot secure a stock allocation, and the market can have an unforgiving attitude to floats that disappoint on listing; an IPO that attracted plenty of attention before listing suddenly has a lower profile.

Sometimes the best IPO opportunities are in the secondary market, soon after listing. An IPO’s share price falls because it was a touch overvalued at listing or because there is high turnover in its stock as the share register settles. Or an undervalued stock at listing rallies on debut, before making new highs in coming months.

The point is: do not feel you have missed out if you cannot secure stock in a float. The best opportunities often come to patient investors who watch and wait for better value, when the initial promotion for an IPO subsides.

11. Do your homework
As mentioned, IPOs have an added layer or risk as the company transitions to a life as a listed company. So read up on the IPO, study its prospectus and compare it to similar listed companies to form a view on its valuation.

Consider using a full-service broker if you intend to be active in the IPO market. Some online brokers offer excellent IPO resources and can secure stock allocations for clients. But a relationship with a broker who knows the IPO market and works for a firm that is active in this space, is valuable.

About the author

Tony Featherstone is the consulting editor of ASX Investor Update and a former managing editor of BRW and Shares magazines. He has written on hundreds of IPOs for the Australian Financial Review or other media publications in the past decade.

From ASX

Upcoming Floats has more information, and Recent Floats and Listings provides information on entities that have listed on ASX in the previous two months.

The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.

© Copyright 2015 ASX Limited ABN 98 008 624 691. All rights reserved 2015.
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