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Spotting great sharemarket floats

Photo of Roger Montgomery, Montgomery Investment Management By Roger Montgomery, Montgomery Investment Management

min read

Learn how to assess Initial Public Offerings, and maximise returns.

Montgomery is fortunate to be able to access many initial public offerings (IPOs) that can provide the opportunity to boost returns to our investors. But one investment truth is that the very best IPOs will, for most people, be impossible to access.

Before feeling envious, realise there is much to understand about the background to IPOs that might have you questioning whether you care about being involved at all.

The average annual return for 2016 Australian IPOs was 35.8 per cent at November 30 and the average first-day return for an Australian IPO in 2016 was 16.6 per cent.

Deloitte reported in March 2016 that the average return for 2015 IPOs was 39.6 per cent, for 2014 it was 70.1 per cent and for 2013 it was 18.8 per cent. All numbers compare favourably to the broader market and perpetuate the enthusiasm many have for participating in IPOs.

Confusion reigns supreme

A recent report by the law firm, Herbert Smith Freehills, showed there were 96 new ASX listings in 2016, up 13 per cent on 2015. Those 96 floats raised more than $8 billion in capital. Information technology (IT) listings represented a quarter of the total and 15 financial companies were listed.

In 2016 four of the 10 top-performing IPOs to November 30 were IT companies, as was the very best, Aurora Labs.

The average return of the tech listings was 69.5 per cent, according to Onmarket Bookbuilds, and only one materials sector company, Soon Mining, made the top 10.

Research by Stein, Roe & Fonham Inc (and cited in many academic articles) suggests that IPOs are underpriced by about 16 per cent on average, to attract investors.

However, short-term returns and share trading patterns might be important to speculators but should not be used as the basis for an investment by investors, who know that in the long run share price performance will closely follow the performance of an underlying business.

Investors are also aware that 35 years of declining interest rates, and promises from President Trump of big corporate tax cuts could inflate returns of more recent IPOs.

On the negative side, in 1995 an academic paper by Philip J. Lee, Stephen L. Taylor and Terry S. Walter, entitled ‘Australian IPO pricing in the short and long run’, was accepted by the Department of Accounting at the University of Sydney and concluded: “The results also show that Australian IPOs significantly underperform market movements in the three-year period subsequent to listing” and “Our long-run evidence shows that IPOs perform poorly in the ensuing three years, with poor performance not confined to any one of the first three post-listing years.”

Much of the financial press has focused on the failings of private equity (PE)-backed IPOs, such as Dick Smith (which collapsed completely), Godfrey, Estia, Isentia, Healthscope and Spotless Holdings (which all plunged following earnings downgrades).

Typically, private equity firms invest as leveraged buyouts or venture capital, often with a view to exiting the investment through a public issue. It is not surprising, therefore, that IPOs being launched by private equity firms may not enjoy the same underpricing typical of non-PE IPOs; you should, therefore, be careful when considering a private equity-backed IPO.

Investors need to look further back to see that a reasonable mix exists between great opportunities, overpriced opportunists and the rest.

While the post-IPO performance of Boart Longyear, Hastie Group, Building IQ, Norfolk Group and Pac Brands might have investors run a mile from IPOs backed by private equity, you should remember that JB Hi-Fi, Invocare and Seek were all private equity-backed floats that have been extremely successful investments for subsequent shareholders.

When considering an IPO, the same business-style analysis needs to be conducted as with any investment. This is not difficult. Avoiding succumbing to the hype surrounding some IPOs can be more difficult than the analysis required to assess them.

Getting started

Step one is to understand the business. Ask yourself, will this business be substantially larger in five to 10 years? In the process of answering you will uncover myriad additional questions. What are the risks to the growth thesis? Who are the competitors and what are the emerging threats? What are the competitors’ growth plans? How stable is the industry? Are my expectations realistic? Has management of this company got a track record?

The less you know about a company’s prospects, the more you are gambling.

It can be useful to score a company on its competitive strengths and weaknesses under headings such as pricing power, stickiness of customers, and the bargaining position of the company with its suppliers and customers.

A cynical hat

When assessing an IPO, it is always best to remember that despite all the academic research, the vendors are choosing to float rather than conduct a trade sale, because they can get a better price.

Of course, if all the money being raised is going into the business rather than to the vendors, that might not be a bad thing. But it is worth remembering that floats are timed generally to maximise the price received.

Further, remember that you are dealing with a much more knowledgeable vendor (and investment bankers behind the float) and you are a less-knowledgeable buyer.

Follow the money

In every information memorandum, a company is required to outline the source and use of funds. This is a very handy table because it sifts the wheat from the chaff very quickly.

It helps to look at how much the company management will own after the listing. Many investors believe that if a CEO has 20, 30 or 40 per cent of the company, their interests are aligned. But that is not the case. The dollar value of the investment in the company by the CEO relative to their wealth elsewhere is a far better indicator of alignment.

If I have a $50-million interest in the company after the float but I have just sold down $500 million before the float, our interests may not be very aligned at all. Will the majority of the management’s wealth be tied up in the success of the business? If not, be careful. Part-time or interim CEOs can do a lot of damage.

What drives earnings?

It is a common misperception that a company that floats is a new company. But many IPOs are of companies that have been in existence for many years. Indeed, the tidal wave of retiring baby boomers will include many who intend to sell their businesses and some of these will be decades old.

Thanks to a long history, investors will be able to dig up a track record of earnings, which can give some insight into earnings persistence.

If a company is defined as “large” (that is, it either generates revenue of $25 million or more or gross assets at the end of the financial year of the company and any entities it controls total $12.5 million or more, and there are 50 or more employees) the company must lodge a financial report and a directors’ report for each financial year. And the accounts must be audited. Therefore, you can obtain a history of the performance of the business.

It is obviously preferable to see a business that is growing and is expected to continue to do so. This is simply because it is through income growth that purchasing power can be preserved.

To establish whether the company will grow its earnings, identify three key drivers and follow them at all times.

In mature markets, often market share will determine earnings growth. Overall growth rates for revenue may not exceed GDP but changes to market share can change the relative earnings growth rates between competitors.

For other businesses – supermarkets are a good example – profit margins are an important driver of earnings growth. When Aldi entered Australia, Woolworths’ world-class EBITDA (earnings before interest, tax, depreciation and amortisation) margins were immediately on the block and have been declining ever since. Other drivers might include productivity or efficiencies, client satisfaction, direct marketing, working capital or even commodity prices.

Valuation

Here is a simple rule of thumb to help know if you are getting a genuine bargain.

Take the equity on the pro forma balance sheet – that’s the estimate of what the balance sheet will look like when the company is listed. Be careful if there is too much in the way of intangible assets – that could mean the equity is overstated and ‘roll-ups’ (companies that consolidate industries through acquisitions) are classic examples of this.

Once you have established the equity, divide it by the number of shares that will be on issue to obtain the equity per share figure.

Then divide the forecast earnings per share by the equity per share figure to obtain the return on equity. If that figure is in single digits, you may want to look elsewhere for your next investment. If it is in double digits and the long-term prospects for the business look good, the value exists generally when the multiple being paid over the equity per share is relatively low.

About the author

Roger Montgomery is the founder of Montgomery Investment Management and the Chief Investment Officer of The Montgomery Fund and The Montgomery (Private) Fund. His book, ‘Value.able’, with his formula for estimating intrinsic value, can be purchased here.

Follow: @rjmontgomery

From ASX

Upcoming Floats and Listings has details of companies that have applied for official admission on ASX.

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.

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