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IPOs are back

Stephen Wilmot

IPOs are back

New year, new companies. 2015 has not so far witnessed the frantic IPO rush of a year ago, but the pipeline of deals is lengthening. Trainline Investments - which runs the popular train-ticketing website www.thetrainline.com - tool-hire company HSS and infrastructure group John Laing are hoping to raise over £300m between them. All three flotations are open to private investors (through intermediaries) as well as institutional investors.

How much attention should you pay to these new issues? Little, if past experience is anything to go by. Since 1987, new London listings have provided an average first-day 'pop' of 8 per cent, relative to the market. But over the two years from the end of that first day they have gone on to lose 9 per cent against the market. These figures - compiled by academics Elroy Dimson and Paul Marsh of the London Business School for the latest annual review of the Numis Smaller Companies Index (NSCI) - offer a timely reminder that the odds are stacked against IPO investors.

This is no anomaly of the London small-cap market: it's a pattern observed on many stock exchanges around the world. The explanation is highly intuitive: at flotation, a company's sellers know more than its buyers. They can IPO when they want - which is when the story is at its most exciting. And they can make that story even more exciting than it would otherwise be by - to name one common practice - calling a halt to hiring 18 months before flotation. After all the window-dressing, the shop floor can look messy.

Economists call this problem 'information asymmetry'. A famous 1970 paper on the 'market for lemons' - that is, second-hand cars - showed how a market can break down completely when the sellers of a less than transparent product, like a second-hand car, know more than the buyers. Because rational buyers assume any used car is no better than average in quality, owners of better cars will not sell, reducing the average quality of used cars on the market further. A vicious spiral ensues, and eventually no cars are sold: market failure.

In theory, this model should be applicable to stock market listings: rational investors ought to have factored the history of IPO underperformance into their calculations, forcing offer prices down. Yet somehow punters always persuade themselves they can spot the exception to the rule. Their mistake is presumably a cousin of the Lake Wobegon fallacy that 'all children are above average'.

So how long does the underperformance effect last? Should investors wait two years for expectations to rebase at a more realistic level, and then pounce? Professors Dimson and Marsh crunched the numbers for all companies in the NSCI and Aim index since 1980 and found a surprising result: the longer a company had been listed, the better it performed.

If you invested only in companies that had been public for three years or less, every pound you set aside in 1980 would have turned into eight by the end of last year. If you'd selected companies with four to seven years of 'seasoning', as the professors call it, you'd have ended up with £18. But then the returns increase hugely. Companies with eight to 20 years of seasoning multiplied investments by 75 times, and those with more than 20 rose by a factor of 106. The implication, as the grey-haired dons enjoy pointing out, is that age is a better investment than youth - at least where companies are concerned.

This may be because deferring to age helps investors avoid overpaying for exciting new companies hyped in the media. As such, this seasoning effect may be a relative of the 'value effect': academics have found that companies with higher dividend yields tend to outperform over the long term. Whatever the explanation, it's hard to argue with 35 years of stock market history. Investors need to be even more than usually sceptical when considering buying into IPOs.

Source: Numis Smaller Companies Index

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