Should you get in on the ground floor of IPOs?

November 15, 2013 6:49 pm

Should you get in on the ground floor of IPOs?

By Elaine Moore

Kicking yourself for missing out on Royal Mail’s blockbuster stock market debut? Don’t worry. There is plenty more where that came from. This year is shaping up to be a bumper year for companies choosing to make their debut on London’s stock markets as confidence in the UK’s recovery grows. So far this year 71 companies have debuted on UK exchanges, compared to 46 in the whole of 2012. After Foxtons, Merlin Entertainments, Esure and Royal Mail, there is now speculation that House of Fraser, Poundland or DFS might be the next household names to go public.All of this activity appears to be good for investors. Shareholders in Royal Mail who resisted the urge to sell immediately have seen prices rise by 68 per cent since the state-owned postal service was privatised on October 11.

The feeling that you are “getting in at the ground level” of a company’s performance and can make big gains from its subsequent success is part of the charm of investing in a company’s initial public offering, or IPO.

That’s particularly true of privatisations, where a company is evolving from a state-owned group to one run for the benefit of shareholders. If you put £1,000 in British Gas when the state-owned energy company listed on the stock market for the first time in 1986, held on through all the demergers and reinvested all the dividends, you would now be sitting on £19,000, according to Fidelity Investments.

More impressively, US statistics company Statista says that anyone who put $1,000 into Amazon when the online retailer first offered shares to the public in 1997 now has$239,000.

Who are IPOs for?

But before succumbing to the excitement and putting money into a floating company, it’s worth remembering that IPOs aren’t really designed with you in mind.

In fact, most of them aren’t open to the general public. Some companies, such as Foxtons, limit their share sales to institutional investors – doing so makes IPOs quicker and cheaper to run.

This year has been unusual in the above-average number of companies actively courting private investors. Take Merlin Entertainments, which owns nearly every sort of theme park you can think of that is not run by Disney (including Alton Towers, Madame Tussauds and Legoland). When it announced its intention to float it included a special offer of discounted theme park tickets for retail investors.

The renewable energy group Infinis said that it wanted to attract retail investors when it announced its decision to float, and Royal Mail boosted the number of sharesallocated to the public.

This is a very good thing, says Gavin Oldham, chief executive of the Share Centre. “Personal investors have been starved of access to primary issues. And if a company has a personal focus to its customer base then it’s natural that they would want to draw those consumers in and build a sense of loyalty to the company. If you own shares inM&S then you feel differently about it to other shops.”

Why does a company list?

Raising the profile of the brand may be one of the benefits of floating, but the main reason that a company lists on the stock market is to raise money. It often pays to look at where that money is going.

Many of this year’s flotations – actual and potential – are companies that were taken off the stock market earlier in the noughties, often by private equity firms. Typically, when the company returns to the stock market, a large chunk of the cash raised is used to refinance the debt and generate a profit for the private equity backer.

“A key question to ask is who owns the company and are they going to keep a stake in the business,” cautions Rebecca O’Keeffe, head of investment at Interactive Investor.

“You want your interests in the longer term performance of the company to be aligned with the owner’s interests.

Companies also float because shares can be used as an “acquisition currency”, and in people-intensive businesses such as media, technology and financial services, as a staff retention tool.

Should you avoid IPOs?

It may seem as though an IPO offers a way to back a company before everyone else gets involved, but you will rarely be the first investor.

Before it listed, Twitter raised more than $1bn from investors according to the website Crunchbase, and it is these early investors who are likely to be the biggest winners from a highly priced IPO.

In addition, underwriters will reap a better cut if the offer is priced highly and brokers will earn fees for selling the stock. This means that it can be hard to find a disinterested opinion about the merits of a company heading for the stock market. One broker likened the usefulness of a company’s prospectus to the TV show Storage Wars, in which buyers purchase the contents of a storage locker, based only on a five-minute inspection.

Ahead of Twitter’s IPO, US newspapers were filled with warnings to individual investors to think twice before jumping in and remember that investing in companies without a long record can be a high-risk move.

Glencore’s flotation gained widespread attention in 2011, but shares in the commodities trader lost 27 per cent of their value three months after listing. Other London floats such as Ocado and Betfair also flopped initially. And shares in Just Retirement, which began trading this week, fell by 5 per cent on the first day.

Some analysts say that the simple fact that companies tend to list when the market is buoyant and they have the best chance of selling shares at the highest price, means investors won’t be getting a bargain.

 

The performance of the 20 biggest IPOs since 2000 has been a mixed bag. Data from Dealogic shows that while the share price ofExperian has increased by 115 per cent from its 2006 offer price, Debenhams’ (another private equity sale) has fallen by more than 47 per cent over a similar period.

A study of 1,500 IPOs by Mario Levis of Cass Business School in 2010 also found that the average IPO underperformed the FTSE All-share by 13 per cent over three years.

So should you buy?

In spite of the risk that an overhyped IPO can lead to price falls later, many companies want to keep a good relationship with their shareholders and will leave some room for investors to profit from the offer price.

Twitter’s stock closed up 73 per cent on the day of its debut and the banks that led Royal Mail’s float are being called to defend their valuation of the company to MPs after prices jumped 38 per cent on the first day.

Ms O’Keeffe at Interactive Investor says that even IPOs that stumble initially can recover over the next few days or weeks. “If demand is high and institutional investors found it hard to get stock initially, then they may be looking to buy.”

The performance of the large IPOs this year has also been positive, she says, althoughesure is one exception.

Investors aren’t completely in the dark when it comes to valuation, says Richard Brown, head of product at execution-only broker TD Direct Investing.

“Don’t underestimate your expertise as a consumer,” he says. “If the company is a brand you like and use then that can help you. Ask yourself what you know about them and how they compare to other similar brands you use.”