IPOs are a special breed of investment. Defying all the fundamental investment rules, a successful IPO can rise ten times its issue price all on the back of ‘hype’ or the potential for future earnings. A good example of this was online food ordering and delivery platform DoorDash in the US. Shares in the IPO shot up 80% when they began trading for the first time. The initial public offering was one of the hottest of 2020.
Yet on the flipside, get it wrong, and an IPO can really cost you. At their most simple, IPOs represent an opportunity for companies to gain access to more capital to continue their growth or in some cases to pay out long-standing shareholders. In the worst cases, they can be opportunistic, poorly timed and based on popularity rather than great business practice.
More often than not, IPOs lead to losses for retail investors. The ones that really do make money, are often over-subscribed or offered to institutional and high-net-worth investor clients of stockbrokers.
So how do you tell a good IPO from a bad one? There’s an old stockbroker saying, “the IPOs you want to buy are the ones you cannot get access to because they’re over-subscribed. The IPOs you want to stay clear of are the ones that fall on your desk begging for your money.”
A recent article written by Gary Rollo, who is the portfolio manager of the Montgomery Small Companies Fund, talks about a process his team uses to sniff out companies with an “under-appreciated or undiscovered competitive advantage with capable management teams that are early in their value creation journey.”
The hardest part about investing into an IPO, he says, it to determine the fair value. Gary says “the valuation regime of an IPO is an unknown, brokers do a good job to select IPOs that they can ‘get away,’ essentially giving the investor crowd what it’s craving, the flavour of the month. And brokers work hard to whip-up demand, this can result in extreme pricing dislocation events.”
While the questions to ask before investing into an IPO are broadly the same as any other investment, actually finding answers is significantly more difficult, and the consequences significant. Rollo offers a unique insight into the events of the last 18 months in the small-cap sector, highlighting the following:
- There have been 110 IPOs since the March 2020 lows;
- 39 have been resource exploration plays, all but two of which were greater than $50 million in market cap;
- There have been 71 non-resource IPOS, 44 of which have a market cap over $50 million;
It is this 44 IPOs of over $50 million that Rollo says is Montgomery’s “investable universe.” Interestingly, he says the median return since IPO is actually minus three per cent. Just 21 of these IPOs are now trading above their IPO price, confirming that IPOs are not the one-way bet that many perceive.
Another major mistake investors make is to invest in an IPO based on a hot theme of the moment or because of FOMO (fear of missing out). Some of the hot themes during COVID were
meal kits, e-commerce and buy-now-pay-later (BNPL) lenders. The issue with hot IPOs is that they generate a lot of attention. With the herd now wanting a piece of the action, FOMO kicks in and the price goes bananas even before listing. This can make a hot ‘theme’ IPO look great in the short run, but once the company starts to disappoint, a share price can fall a lot faster than it can appreciate.
According to Rollo a good example of a company this on the ASX is Youfoodz (ASX: YFZ). It “tried to capitalise on the market’s appetite for meal kit delivery that boomed during COVID. Its IPO was priced at $1.50, but it never traded within cooee of that, its best print was $1.32.”
It’s been one way traffic since then, the share price down before the recent takeover offer at just 90 cents. It takes the award for the worst post-COVID IPO (to date anyway). My Food Bag (NXZ:MFB), New Zealand’s equivalent of Youfoodz, provides further illustration of hot theme/hot money loser, and is trading 28 per cent below its issue price.” Other failures, thus far at least, include Adore Beauty, Mydeal.com.au, Payright, Harmoney Corp, Ai-Media Technologies.
The Montgomery Small Companies Fund IPO report card shows the team has a 75 per cent hit rate.
So far this year, there have been 81 IPOs with another 24 booked in for the next two months. One IPO hopeful doing the rounds is customer experience quality assurance platform Cyara. It is pursuing a $500 million-odd listing and is looking to tap investors for $200 million. According to the Australian Financial Review, the platform automatically tests the performance of a company’s customer service technologies, such as call centres and web chat interfaces, detecting if there are bugs in the process.
Keep in mind the IPO screening process mentioned above to vet out the bad eggs.