How to decide whether to board a float

By Deputy Editor Tim Bennett Oct 03, 2007

Tim Bennett

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Backing the right firm when it first lists on the stock market (at its initial public offering, or IPO) could transform your portfolio. If, in 1919, you’d happened to put $40 into a newly listed drinks firm called Coca-Cola, you would now have more than $5m. That said, not all IPOs are on a path to riches; 63% of new listings don’t even survive their first decade. So how do you choose which to back – especially when the UK market saw 55 new issues on the main market and a full 462 on Aim last year alone? Here are five tips for avoiding IPO trouble.

1. Don’t catch a dying wave

All too often investors jump into a new issue, hoping to cash in on the latest growth story, not realising that the owners are using the same IPO to cash out as the sector peaks. Many commentators have suggested that the recent listing of Blackstone signals the top of the private-equity boom, and with the shares now languishing below the offer price (despite an initial 13% surge) it seems that they may be proved right. The rush to list hedge funds such as GLG also smacks of a race for the exit.  Keep an eye on news about the directors and their shareholdings in a company– will they still be around after the flotation? If these insiders – who should know most about the company and its prospects – are selling out, then why should you buy in? 

2. Look at the firm’s track record

As long as a newly listed firm is financially sound, sells a decent product or service and is sensibly priced, you’re probably on to a winner. So, avoid loss-making firms unless you’re an adrenaline junkie, and look for firms that can charge premium prices, reflected in a decent (20% or more) gross margin (gross profit divided by sales) and return on equity (again, at least 20%).  

Strong cash flows are also important and are vital if gearing (the ratio of debt to equity) is more than 50% as the group will need to pay a high amount of interest just to stay alive. Check the quality of operating profits by ensuring the figure is supported by at least the same amount of operating cash flow. This data is in the “reconciliation of profit to cash generated from operations” note to the accounts. Then check whether the proposed offer price represents value for money. A couple of useful screens are the price-to-sales ratio (market capitalisation divided by turnover) and the price-to-book-value ratio (market capitalisation divided by shareholders’ funds). A score of below one suggests the shares are good value.

3. Don’t ignore the main market

In 2006, Aim attracted eight times as many companies as the main market from ‘hot’ sectors such as oil and gas, renewables, eastern European property and China. This was largely down to light regulation; for example, there are no minimum-size or trading history restrictions placed on those seeking to join. But this ease of access also creates dangers – Aim-listed firms are often young, untested and volatile. Buying shares in the main market provides what Peter Temple calls an “additional quality control”, because there are strict rules about who can join. And this doesn’t mean sacrificing the chance to land a ‘ten-bagger’. Impressive returns have come from the likes of Paypoint, Halfords, Burberry and Xstrata, all main-market offerings with a decent trading history and strong management before floating.

4. Stick with what you know

As Warren Buffett puts it, good investments “must be relatively simple and stable in character”, not “complex and subject to constant change” – another reason to avoid the current crop of hedge-fund IPOs. How many investors really understand how hedge funds make money, or have any idea of whether they will still be profitable in five years’ time? Long-term successes like Starbucks, JD Wetherspoon and Wal-Mart share a strong brand, a scaleable business model and already had strong positions in their sectors when they listed – and it’s easy to see where their profits come from.

5. Get in early

If you are keen to buy into a new float, but have not been able to take part in the initial offering, it’s best to either get in early on day one – a buy order placed via your broker with an upper price limit will ensure you don’t overpay – or wait until the initial euphoria had passed. The hype around a new issue can rapidly push the share price higher than the fundamentals may warrant. Hargreaves Lansdowne, for example, saw a 36% rise in its first week of trading in May, but at 209p the shares are already below their 218p peak. Those who got in at the start will still be in profit – but those who bought just a few days later would now be in the red.

Published in How to invest | More articles by Tim Bennett

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