Treat IPOs with caution

Investing in IPOs is a risky business.

There were 480 initial public offerings (IPOs) on the US stock market in 2020, an all-time record that will almost certainly be eclipsed by 2021. Just four months in, we have already seen 448 IPOs. Some have halved in value and others are up 70%.

Investing in IPOs is a risky business. This is capitalism at its purest.

An IPO is the process of a company coming to market, ringing the bell / blowing the horn / shouting from the rooftops and raising a ton of money in the process.

IPOs are the raison d’être for stock markets. Companies tap into pools of capital and raise money for growth while providing shareholders with the ability to trade shares and take a view of the company’s prospects.

A less-exciting approach that has become more popular recently is a direct listing. The company lists on a stock exchange and the existing shareholders sell a portion of their shares to new investors.

Cash changes hands among shareholders new and old, rather than flowing from new investors into the company bank account. A company would do this to achieve a liquidity event for shareholders, such as venture capital firms that are ready to exit the investment and go shopping for yachts instead.

The highest-profile direct listing of 2020 was Palantir, after Slack Technologies took the same route a year prior. Some market commentators expected Airbnb and DoorDash to follow a similar approach in 2020, but the pandemic put serious pressure on balance sheets and many companies chose to raise money in a hot market instead.

A direct listing is given a reference price by the exchange, which is an indication of where the stock might open for trading, although it is rarely the case that shares change hands at that price. In a market like this, the shares typically open significantly higher.

In an IPO, the company offers shares at a particular price and investors register their intention to subscribe. The company makes allocations accordingly, in consultation with its investment bankers, aiming to create a robust shareholder register that also has a sufficient spread of shareholders to encourage decent volumes of trade in the shares.

In an oversubscribed IPO, there are more investors than there are shares available. This can cause the share price to pop on the first day of trade, as investors acquire shares in the open market. It doesn’t always work out of course, with a drop in price on the first day regarded as a poor outcome.

Deliveroo experienced that first-hand, with a disastrous listing in London in April 2021. Despite being the biggest IPO in London since 2011, the shares closed 26% below the listing price on the first day of trading.

The ultimate failure, however, is to not raise the desired capital in the IPO. If investors aren’t interested, the company will pull the listing and blame general market conditions. That’s exactly what Consol did in 2018 when investors weren’t queuing up to buy into a heavily indebted business in South Africa.

Unfortunately, those “market conditions” are a real issue and have been a feature of the JSE for some time now. In a market that has gone mostly sideways, investors have been nervous about “SA Inc” businesses that are exposed to our local economy with pedestrian growth. This is especially true for companies with highly geared balance sheets, usually because of private equity ownership or an aggressive acquisition strategy.

New listings inevitably get investors excited. There’s the promise of a new business to add to the portfolio, accompanied by a detailed prospectus that makes a compelling case for investment. However, investors need to proceed with caution when it comes to IPOs or direct listings.

Before the recent market flurry, the previous record year was 2000 with 397 IPOs. Shortly after 2000, the Dot Com bubble popped.

The Nasdaq took 15 years to recover from it.

This isn’t to say that we are at a bubble stage and that everything is about to fall over. There are sensible arguments in support of why today’s market is different to Dot Com, like the debasement of money due to government stimulus and the incredible growth rates being achieved by platform businesses that go some way towards justifying high valuations.

However, it is true that a bumper year for IPOs can be an indicator of whether a market is running too hot. Whether it could cool off by 5% or crash by 35% is a matter of analysis and opinion.

Investors should remain objective and cautious when it comes to IPOs. The best strategy is often to let the opening skirmish take place, waiting for price discovery as buyers and sellers battle it out in the initial stages.

That certainly would’ve worked well with Facebook, which suffered sharp drops in the share price in the period after its IPO in May 2012. We all know what happened in the years thereafter – the IPO price of $38 is a distant memory for a company currently trading at around $330 per share.

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