The New Arrivals

Boom and bust

One thing we’ve learned from the history of IPOs is that investors seem to make the same mistakes time and again. Despite the complex financial wizardry used by modern analysts and brokers, it can prove extremely difficult to back a winner. Apart from the abstruse financial jargon which keeps most ordinary investors at bay, it’s easy to be taken in by a great story: the pre-listing research is full of wonderful descriptions of a company with seemingly unlimited growth potential. The prospectus, tailor-made by PR firms and advisers, sets out an apparently air-tight investment case, trumpeting strong historical trading and equally bullish forecasts to justify the often eye-watering valuation. Online fashion retailer Boohoo's (BOO) punchy rating when it listed earlier this year is a prime example. It came to market at 50p, giving it a market cap of £560m on pre-tax earnings of just £3m (suggesting a historic PE ratio of well over 200 and forward PE ratio of over 60). During the first day of trading, the share value increased to as high as 75p. There has also been a raft of small tech and biotech companies that have come to market in recent months, many of which have garnered huge investor interest, despite never having reported positive earnings.

Mouhammed Choukeir, chief investment officer for Kleinwort Benson, says bullish investors in today’s low-yield environment have been captivated by the stories of charismatic visionaries and their start-ups. “Having had little to go on but a canny insight and an unshakeable faith, it is often thought that these intrepid entrepreneurs, and those who believed in them early enough, can reap fantastical profits once that exchange bell has rung,” he explains. “Imagine the artistry where value rests largely on perceived potential. The market might have got carried away with the hype over Boohoo, leaving it willing to pay a wildly expensive price for hypothetical growth. But the most worrying part of this frenzy is that Boohoo.com is a relatively profitable and mature company when compared to many recent IPOs. Nearly half of all companies that were brought to market in the US in the first quarter of 2014 were biotechs and not a single one had reported positive earnings.”

Online electrical retailer AO World (AO.) raised a number of eyebrows with its overly optimistic rating third year, which Professor Arif Khurshed*, a leading expert on the UK IPO market based at Manchester Business School, branded “the biggest example of recent overvaluation”. “It was amazing to see how it was priced and even more bizarre that the shares did well the first day of listing,” he said. “I didn’t think the valuation was realistic, particularly compared to Dixons (DXNS) and Carphone Warehouse (CPW). It made me shudder.” Shares in AO are now at 229p, well below the float price of 285p in March, while Boohoo’s are trading at 43p, well below the 50p placing price and nearly half of the highs reached on the first day of trading. Card Factory’s (CARD) IPO received a disappointing response on admission on 20 May, with the shares now 12 per cent below the float price.

So, amid all this heated speculation and with such a disparate list of companies coming to market, with wide ranging price tags, how can you possibly separate the wheat from the chaff? There are a several steps ordinary investors can take to help navigate the murky world of IPOs, and often it comes down to the same kind of due diligence one would employ when investing in any other company. Prof Khurshed has a number of useful tips for retail investors:

1) Look at a company’s debt level. If debt has increased substantially in the two years leading up to the IPO, care should be taken as these firms may end up having to choose between growth and managing their debt.

2) What’s the reason for the offer? Usually it will be one or several of the following: pay off debt, help existing investors realise their investment in the company, fund growth, deal with cantankerous legacy issues in the management structure. Most IPO firms use part of the proceeds to retire their debt and the remainder to fund growth. If almost all money raised is being used for debt retiring or to pay existing shareholders, there should be a sound explanation.

3) How much equity are the existing shareholders keeping after the admission and what are the lock up agreements? If they’re keeping a significant portion of shares and have long lock-up arrangements, this can be interpreted as a positive signal, in that they are committed to work in the interest of all shareholders and believe in the company’s growth story. If they’re dumping their shares, that could be a bad sign.

4) What is the profit history? What is the source of profit and can the increase in profit be attributed to increasing sales? Does the firm operate in a niche area and is it expanding into other markets and have patent protection for competition?

5) Look at the balance sheet. If inventories are growing faster than sales, it might mean that demand is falling. The cash flow statement provides insight into cash coming in and out of a company: a healthy company should generate excess cash from operations.

6) The dividend policy is important for income-seeking investors

7) Don’t read too much into profit forecasts!

“The game is always dangerous and the history of IPOs tells us investments have given negative returns over three to five years, so don’t go for a lengthy investment,” warns Prof Khurshed. “If you do want to invest, do your homework. All documents can be read online, don’t get emotional and make a sensible judgement.”

Why all the hype now?

You may have noticed that the City is in the grips of an IPO boom. From well-known names like Royal Mail, Pets at Home and Poundland to Foxtons, Safestyle and Merlin Entertainment, this past year has seen a raft of new listings in London. In fact, 2013 marked the most active year in the London IPO market since the start of the global financial crisis, with 14 main market listings, raising £5.2bn, compared with 11 in the previous two years. The Alternative Investment Market also had a bumper 2013, with 51 deals raising £662m, the highest in over three years. 2014 has started on a high too. The first quarter alone was the strongest IPO market the capital has seen in two decades, as 24 listings across the Main Market and Aim raised a whopping £3.9bn. Retailers accounted for the lion’s share of activity with eight IPOs raising £2.4bn, while the Aim had the strongest quarter in over 20 years, featuring fast-growth companies across sectors such as life sciences, technology and manufacturing. There have been many more new arrivals since then, including Patisserie Valerie (CAKE) Card Factory (CARD) Saga (SAGA) and Shoe Zone (SHOE), and plenty more are lining up to list: Game Digital, WizzAir and Zoopla - to name but a few.

So why the rush to go public? Well, during the financial crisis the tough economic environment meant the IPO market was effectively closed for businesses, forcing companies to postpone their IPOs. This has created the current backlog of businesses waiting in the wings today. Many are private-equity backed firms looking cash in now while markets are hot. In fact, of the 14 main market listings last year, 11 were private-equity backed businesses.

“Whenever we have had a financial crisis, one casualty is the IPO market,” explains Prof Khurshed. “Now, a number of things have happened at the same time: the UK economy has turned a corner, stock markets have been bullish and the volatility at the height of the crisis has gone.” And of course, there is the momentum effect. When one company lists successfully, it’s a catalyst for others to follow suit. In this case, Royal Mail’s hugely successful IPO – for shareholders at least - captured people’s imaginations. Saga’s offering to retail investors was said to be over-subscribed, probably in the hope that its performance might emulate that of Royal Mail.

FUTURE IPOS TO LOOK OUT FOR

Too hot to touch

There have been suggestions that the London IPO market is overheating. Fat Face scrapped its planned IPO this month, citing wrong market conditions, alongside foreign exchange company Travelex. Other companies, such as Saga, have had to either price their shares at the bottom end of the range or revise down their offer prices. And while shares in many of the recent entrants have surged on the first day of trading, known as the aftermarket, they are starting to ease back slightly. Main market IPOs in the first quarter of 2014 traded on average 6 per cent above their initial placing price in the aftermarket, according to data from EY. Over 2013 as a whole, new admissions traded on average 31 per cent over their offer price at year-end. “It’s important to consider that those businesses coming to market this year are more confident of pricing and achieving a higher valuation than those which listed in 2013, and as a result, post float, are not experiencing such a significant kick in trading above their initial asking price,” say EY's analysts. However, they still believe the IPO market will remain buoyant certainly through 2014 and perhaps well into 2015. Prof Khurshed takes a slightly different view. He reckons a bubble is starting to emerge, but says that we’re still some way off the end. “The majority of IPOs, with the potential exemption of Royal Mail, have been priced at the higher end of the range and have managed to produce strong after-market performance, possibly due to the healthy supply of available investor funds given the low quantity of recent listings. The question is whether subsequent flotations will receive the same level of favourable investor treatment that we saw last year. The next quarter or six months will be crucial. If IPOs are well priced and people don't get burned, that will see more companies follow suit. But if the next few IPOs mess up, the market will be more cautious."

Bear in mind too that aftermarket pricing doesn't reflect long-term performance. Often, the shares drop off after the first day of trading. In fact, Prof Khurshed’s extensive research into the UK IPO market unearthed several interesting trends that potential investors may want to consider. One is that highly underpriced IPOs, whose prices surge immediately after listing, tend to underperform in the long-run. Royal Mail might be the exception, though, given it was a state-run privatisation IPO. These tend to perform very well in the long-term and are often highly profitable investment strategies. Our own IC data has found that a £100 investment in Associated British Ports on the first day of trading in 1983 would have grown to £7,148 by March 2004. Similarly, £100 invested in BP would have grown to £5,155.

Further interesting findings from Prof Khurshed’s IPO research are as follows:

■ The more profitable the UK company is before the IPO, the worse its long-run performance;

■ The larger the size of the company the better the long-run performance;

■ Multi-national companies tend do perform well in the long run;

■ The higher the stake sold by the existing shareholders at the time of the IPO, the worse the post-IPO performance;

■ On average, IPOs underperform in the longer run. Historically, they're down by 20 to 25 per cent after five years.

Shareholder returns

If you’re going to subscribe to shares or are thinking of investing in a newly listed company, be cautious. Studies of almost every stock market in the world have shown that on the first day of trading, on average, IPOs trade at a price which is higher than the offer price, particularly in a bull market. That’s great for big institutions who can get in at the offer price and dump the shares quickly, but it’s bad for ordinary investors from whom it's nigh on impossible to do so. With the exception of Pets at Home, Royal Mail, Merlin and Saga, the majority of IPOs coming to market only have institutional offerings. As some investors discovered with Boohoo, trying to get in on the action on the day is often a losing proposition.

Interestingly, UK IPOs tend to underperform other quoted companies and the benchmark by as much as 10 to 50 per cent over three to five years, according to Prof Khurshed. Therefore, they don’t necessarily make a great investment anyway. One study looking at IPOs from the mid 1980s to 1990s found that a £1 investment in a UK IPO was worth less than 85p three years later. Moneysupermarket offers a good recent example. Shareholders who bought in at the offer price of 170p back in 2007 and held on to their investment would have seen the share price fall to 80p by the end of December 2010 (although the company did pay out huge dividends). Today the price hovers around 174p.

Survival of the fittest

Share performance is important, but survival is a key metric, particularly in the case of the Aim, which is by nature more risky. Prof Khurshed and his team have looked at all the IPOs that floated on the Aim since its inception in 1995 through to the end of 2004 and tracked them until July 2009. The study revealed that in the first year of the IPO, 6 per cent of Aim companies were de-listed: 2 per cent because of merger or acquisition, 1 per cent underwent voluntary liquidation, 2 per cent had their quotations suspended and the remainder delisted for other reasons. In the second and third year after IPO, the failure rate jumped to 25 per cent, of which half were down to mergers or acquisitions. Over the full five year period, nearly 55 per cent of IPOs had left the Aim, but the major reason was merger or acquisition, and that's usually good news for the company being acquired. “This result has important implications for investors,” says Prof Khurshed. “Those who intend to be long-term investors in IPOs on the Aim not only face the risk of underperformance, they also face an investment in companies of which half would not survive beyond a five-year period.”

As at 22 May 2014

The end game

From grain traders in ancient Mesopotamia to slick city traders of today, stock markets have evolved from their rudimentary roots into the professional, regulated institutions we have today in the likes of the London Stock Exchange and the Nasdaq. But when it comes to betting on new companies, there’s still no fail-safe way to avoid huge losses. If you’re looking for a sure bet, history suggests an IPO is probably not the way to go, unless it’s a Royal Mail-style privatisation. If you do want to go down the IPO investment route, the best thing is to go for companies with sound track records, good corporate governance and viable, realistic growth plans, backed up by credible projections. Debt is an important factor too. The bigger and more global the company, the better, and it’s very important that the funds are being used for more than just paying off debt and rewarding existing private equity shareholders, the latter of whom should ideally still have a significant stake in the company long after admission. And remember, the performance of a stock immediately after listing isn’t a great doppelganger for future growth – so don’t rush in to invest on the first day. With a wave of companies still looking to take advantage of the buoyant market to raise capital, we’ve no doubt 2014 will be home to a slew of new IPOs. Please, tread carefully.

IPOs: what you need to know

Timeline of an IPO

Intention to float announcement. This is when the company sets out its stall. The announcement will typically give some background information on the company, detail which market it is planning to list on and whether there will be a retail offer.

Publication of prospectus. Much more detailed than the intention to float, this will contain some financial information, a fuller analysis of the company’s prospects and an offer price range.

Offer period begins. Usually lasting two weeks, this is the window when you can apply for shares through an approved intermediary.

Offer period ends. Investors are allotted shares and the final price is announced

Admission to market: Trading in the shares begins. There may be a few days of conditional trading when institutions can trade the shares off-exchange. This is followed by unconditional trading.

Deciding whether to invest

The prospectus will be your main source of information. It should tell you what the company does, its strengths and weaknesses and what it is using the money for. It should also provide some financial information that you can use to value the shares.

Let’s look at the Royal Mail prospectus to see how potential investors might have valued the offer. The offer price range was 260p to 330p with 1 billion shares in issue post the float. Royal Mail outlined plans for a dividend payment of £133m in its first year after listing, which it said was roughly two-thirds of the £200m payout it would have made had it been listed throughout the year. It also said it planned to pursue a “progressive” dividend policy.

From that we can glean that investors should expect a dividend of 13.3p a share in the first year, rising to 20p or more in the following year. At the bottom end of the price range, that suggests a 5 per cent dividend yield in the first year, rising to almost 8 per cent the year after. At the top end of the price range, the figures are 4 and 6 per cent, respectively.

Given that the yield on the FTSE 100 is around 3 per cent, Royal Mail’s offering certainly looked eye-catching.

We can also have a bash at some earnings-based valuations. Historic net profit was given in the prospectus as £566m, which works out at 56.6p a share. At the 295p midpoint of the price range that gave an earnings multiple of 5 times. Again, that looked good value compared to the FTSE 100’s 14 times.

How to buy shares in an IPO

Not all IPOs are open to retail investors. Those that are will usually appoint stockbrokers and share dealing services to act as intermediaries. Retail investors submit a request for shares to these intermediaries who apply for shares in the IPO on their behalf.

The intention to float document may give a contact number for the intermediary offer and the list of companies acting as intermediaries is usually available in the prospectus or on the company’s website.

The Pets at Home IPO for example had eleven intermediaries including Barclays, Hargreaves Lansdown and Interactive Investor. An intermediary cannot charge a fee for the share application. But there will usually be a minimum amount you can invest. For Pets at Home this was £1000.

Royal Mail was a little different in that there was a direct retail offer that allowed investors to buy shares through a government website, rather than go through intermediaries.

Trading before and after the float

Spread betting can allow investors to make a bet on the shares before they officially begin trading on the exchange. The Saga float, for example, had announced an expected price range of 185p to 245p implying a market capitalisation of between £2.0bn and £2.5bn. But the shares floated at the lower end, at 185p.

Spread-betting provider IG offered a market on Saga’s anticipated market capitalisation at close on its first day of trading. Rather fittingly in Saga’s case, this is referred to as a ‘grey’ market. IG’s price was at one point selling at an implied market capitalisation of £2.2bn and buying at £2.35bn.

This can be a useful tool for investors who expect a lot of volatility on the company’s expected valuation in the run up to the float. It can also provide an alternative way to participate in an IPO for investors who do not wish or are unable to follow the usual IPO timetable.

A word of warning on investing after the float. If a share price climbs immediately after the IPO, investors that missed the boat may see the price rise as reassuring and climb on board. But investors who were allocated shares in the IPO may soon sell to lock in those gains, a tactic known as ‘stagging’.

It is not unusual for shares to spike in the first few days of trading then drift downwards. The RM2 float at the back end of 2013 is one such case. The star-studded board (Paul Walsh ex-Diageo and Stuart Rose ex-M&S) created a buzz and the shares closed up nearly 15 per cent on day one, at 101p. But then they started falling. The shares are now down to 61p.

How recent new entrants are performing