At one point or another, many investors have considered investing in an IPO or a stock that recently completed an ASX listing. However, nothing is ever certain in this part of the market, with a long list of failures like Myer (ASX: MYR) and Dick Smith often overshadowing successful IPOs like A2 Milk (ASX: A2M) and Afterpay (ASX: APT).
This year has been a subdued affair for IPOs, at least when measured by the size of capital raised. As at December 12, 2019, the IPO market had raised $6.7 billion since the start of the year, down 21% from last year’s total of $8.5 billion. While macroeconomic concerns have contributed to a reduction in the number of listings, several high-profile IPOs like Latitude Financial have been pulled at the last minute amid underwhelming demand.
Earlier this week, the ASX announced plans for a February unveiling of a new NASDAQ-like index for tech stocks called the S&P/ASX All Technology Index. With industry insiders suggesting this may increase the number of companies looking to IPO next year, what are some of the things to consider before investing in an IPO?
Confirm your investment strategy
With no track record as a public company, and often limited operational insight, IPOs are a high risk proposition. A great deal of the IPO pitch relies on a flashy prospectus and bullish investor presentations, both of which can create overly optimistic expectations among investors.
While potential profits may be high, as has been the case with some of this year’s IPOs like Uniti Wireless (ASX: UWL), up 520% at the time of writing, and Viva Leisure (ASX: VVA), up 195%, losses can also be quite significant. Take Candy Club (ASX: CLB) for example, which is currently down 70% since listing in February, or Cronos Australia (ASX: CAU), which has dived 58% in just over a month. Even gains can quickly turn to losses.
On this basis, you really want to be sure of your investment strategy when you consider investing in an IPO. You should take into account your risk appetite and investment horizon. Viewing IPOs as a quick opportunity to make money is naïve if not foolish. Make sure you only invest in IPOs that align with your investment strategy. If you don’t, you may want to ask yourself why you are considering investing in that IPO in the first place.
Does the IPO align with your investment strategy?
Exercise caution when identifying IPOs
There is often significant publicity surrounding IPO transactions, however, this doesn’t necessarily correspond with success. Using Latitude Financial as an example once again, there was no shortage of publicity drummed up by the Australian broker community ahead of the company’s IPO pitch, however, investors weren’t buying it.
Instead of falling for the headlines, cut through the hype and identify the reasons for the IPO. Which existing holders are selling down and why? What is the overriding purpose of the listing? Typical reasons include enhancing growth, clearing debt, completing a transaction, building the company’s reputation and providing liquidity to existing holders.
Many investors have become wary of investing in private equity IPOs because of their connection to some failed ASX listings. Although this trend does not necessarily hold true in every instance, it may be something to consider as far as public sentiment. On the other hand, it is generally a positive sign if substantial holders or management indicate they will increase their shares in the company.
The most important thing driving near-term price action for an IPO is demand. With that, you will want to cut out the noise and do your own research to identify just how much demand the IPO has received, and how it might be received upon debut. You may choose to look at the track record certain Australian brokers have leading IPOs to market, however, this should not be relied upon.
Do your homework on the reasons for the listing and the level of demand
Scrutinise the fundamentals carefully
Unlike stocks that are already listed, you don’t have any trading history to assess before considering an IPO. That means ‘fundamentals’ of the company and the ‘deal’ should be a focus. This may be easier with larger IPOs as smaller companies typically have limited financials to support their valuation and it may seem like a contradictory proposition to consider their ‘value’.
However, these companies are often listing because they require funds to sustain or grow operations. You will want to assess how these funds will be used and decide whether you believe they are likely to generate opportunities or business growth. Furthermore, you may wish to loosely value the shares by comparing the company against ASX-listed peers.
Sound financials are important for long-term success, however, in the short-term they may not necessarily be the only ‘fundamentals’ to consider. The key product or service and the industry in which the company operates should be considered, as should management and directors. You will want to assess their skills, qualifications, history, salaries and performance bonuses. The shareholder register may also indicate the ‘quality’ of the backers supporting the company.
On top of that, it is important to look closely at escrow provisions, which are the restrictions on existing shares. This may indicate the ‘free float’, or how much stock can trade on the first day of listing. A high volume of escrowed stock may have liquidity implications.
Above everything else, the most critical thing is to review the risks associated with the company and the IPO, including future funding requirements, regulatory hurdles, competition, exploration risk and much more.
Are the building blocks in place for a successful IPO?
Focus on what you know
At the end of the day, you wouldn’t invest in an existing stock if you didn’t understand what the company does. The same principle applies to IPOs. It is unwise to invest in a company or IPO that you don’t understand.
Capital preservation is fundamental to build sustainable wealth. There will always be another opportunity to consider in due course. In the meantime, however, you can afford to be selective with IPOs. This means confirming your investment strategy, exercising caution and scrutinising the fundamentals carefully.
SelfWealth Ltd ACN 52 154 324 428 (“SelfWealth”) (Australian Financial Services Licence Number 421789). The information contained on this web site is general in nature and does not take into account your personal situation. You should consider whether the information is appropriate to your needs, and where appropriate, seek professional advice from a financial adviser. Taxation, legal and other matters referred to on this website are of a general nature only and should not be relied upon in place of appropriate professional advice.