Initial public offerings of ‘new’ shares provide a great pipeline of potential investments
2017 was a busy year for IPOs (initial public offerings) on the London market – 106 of them raised £15bn in funds for the companies involved. Almost half of these (49) were via the AIM market, a 29 per cent increase on the number recorded in 2016.
This year has started more slowly, but we have still seen 15 companies join London’s main market (to end April), while AIM has welcomed 12. Just last week Cyber security firm Avast floated on the LSE and marked the biggest IPO on the exchange since July 2017.
There is a huge universe of existing shares to choose from. There are 946 companies on the LSE’s Main Market and a further 941 on AIM. The two are referred to as the ‘secondary market’.
The ‘primary market’ on the other hand covers instances such as IPOs when we can invest in ‘new’ shares; this also includes placings and rights issues, where a company raises money by selling shares. While placings and rights issues raise additional funds for a company listed on a stock market, an IPO deals with the initial admission of a company’s shares to an exchange.
The primary market can provide a good pipeline of potential investments, particularly at the small-cap and micro-cap end of the market, but how should investors decide which of these IPOs to invest in and which to pass on?
In many respects, the analysis of new companies listing on the market is the same as for existing stocks. So for us this means applying our investment process to look for ‘Economic Advantage’ in the form of at least one of the three intangible assets we seek: recurring income, intellectual property and strong distribution networks.
We need to gain an in-depth understanding of a company’s business model and characteristics to make a judgement on whether it possesses these intangibles. The ability to conduct this kind of background research on a business is largely unaffected by whether we are dealing with an IPO or established stock market listing.
We do, however, encounter some differences when it comes to historic financial information. For currently listed companies there is usually a wealth of historic financial information and reports which can be delved into. By contrast, a company approaching an IPO – while providing documentation including a comprehensive prospectus – will typically have less historic financial information available, especially if the business is itself relatively young. Historic balance sheet and profit and loss accounts may additionally need adjusting if the IPO proceeds will fund changes to the business or balance sheet – by paying down a chunk of debt for instance.
Despite the uncertainties created by the absence of a ‘track record’ as a listed company, there are compelling reasons to selectively participate in IPOs.
Why invest in IPOs?
The most obvious attraction is valuation. All things being equal, shares in a company coming to market will be available at a discount to listed peers in order to provide compensation for the uncertainties. As the company proves itself over time, this discount would be expected to narrow.
Investors willing to conduct proprietary research and meet management can therefore benefit from this risk discount narrowing – an opportunity that is not always available on the secondary market.
As well as a risk discount, another factor often leading to attractive IPO pricing is the desire of vested interests to ‘get it away’. If shares in an IPO are priced too expensively then they will be under-subscribed, damaging the credibility of the broker and leading to the IPO being cancelled, or postponed and reset at a lower level. This creates a bias to price IPOs keenly in order to attract interest, create over-subscription and raise the likelihood of the share price performing well initially.
A further appeal of IPOs is that they often enable investors to tap into new, emerging industries and ‘get in on the ground floor’. While this opens up the possibility of significant upside, it also requires a discerning eye to avoid investments with faddish or bubble characteristics which are aiming for blue sky returns but have little prospect of achieving them. We look to reduce the chance of exposure to risky stocks by only investing in profitable companies and avoiding those with weak balance sheets or an overaggressive approach to acquisitions.
Because we are very selective in judging which IPOs to participate in, we turn down far more opportunities than we invest in. But if we see evidence of Economic Advantage characteristics which are converting to good cash flow returns, we will then look at the pricing of the IPO to see if an attractive risk/reward trade-off is available
Of the 13 stocks we have added to the Liontrust UK Micro Cap Fund over the last year, four were via IPOs.
Historically, some of our funds’ most consistent performers have been sourced via IPOs. Craneware is a great example, having entered our portfolios on its stock market flotation in 2007 and gone on to provide excellent returns. It has been more than a ‘16 bagger’ in investment jargon – on a total return basis, with dividends reinvested in the security, it has made investors more than 1600 per cent over the course of a decade .
Craneware is the largest provider of pricing and billing systems to American hospitals and is a relatively rare instance of a stock which possesses all three of the intangible assets our Economic Advantage investment process looks for.
Victoria Stevens is co-manager of Liontrust UK Microcap fund.
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