Some investors view initial public offerings (IPOs) as a golden opportunity, others see them as fool's gold. Indeed, for every hot IPO such as Google that zooms into the stratosphere and creates tons of investor wealth, there are countless duds that languish below their offering price for years.
After lying low during the recent market crash, the IPO market has bounced back since mid-2009 in deal flow and proceeds raised. And one of the most intriguing public offerings in years, General Motors, is expected to occur sometime in November.
According to Renaissance Capital LLC, a money manager and institutional IPO research firm in Greenwich, Conn., there were 256 global IPOs this year through August, a 495% jump from the same period the year before. That figure was just 42 fewer than the combined totals from the prior two years, when the market downturn clobbered the IPO market. Total global proceeds raised as of August 31 were $117 billion, a 341% rise from the period the year before.
And IPO activity in the U.S. is also up significantly against the past two years, though not as strong as the overall global rate, which is fueled by China and other Asia-Pacific markets.
That said, Renaissance Capital reports that roughly 70% of IPOs in the U.S. this year have been priced below their expected offering ranges. IPOs track general market conditions, and skittishness toward equities since May has had a negative impact. "In times like this when people get hurt, moneymoves away from risk capital such as IPOs," says William Smith, Renaissance Capital's president and CEO.
Companies needing to raise cash in the public markets are facing an indifferent audience, forcing underwriters to downsize deal sizes to make them more appealing to investors. And reduced pricing sometimes leads to outsized first-day returns, or "pops" on new issues.
A prime example is MakeMyTrip Ltd., an Indian online travel company that debuted on August 11 and had a first-day pop of 89%. It kept rising, and was up more than 130% as of early September.
But MakeMyTrip, one of this year's most successful IPOs, is an extreme case. Morningstar Inc. found that as of the end of August, the average IPO in the U.S. this year gained 7% on its initial trading day, but about 60% of IPOs have trailed the S&P 500 thereafter.
According to Smith, the underpricing of IPOs is creating a buyers' market for some of the higher-quality companies going public. "There's great valuation in the market because there are some wonderful companies coming out at rock-bottom prices," he says.
IPOs were all the rage during the dot-com era, but now the concept is mud to many retail investors who got burned chasing new public offerings of unprofitable Internet companies that imploded during the tech wreck.
By and large, the IPO market in the U.S. is now dominated by institutional investors. "The man on the street is still nervous [about IPOs]," Smith says. "But institutions are very heavy into IPOs, which is why volume is the strongest it's been in three to four years."
And, he adds, their ability to put demands on underwriters is one of the reasons many IPOs are getting priced at low valuations.
Recent valuations might be enticing, but the long-term performance of IPOs isn't. Josef Schuster, principal portfolio manager of the Direxion Global Long/Short IPO mutual fund, says roughly 60% of IPOs are under water after four years in the public market.
And that's enough reason for some folks to say "no thanks" to these offerings. "What would lead me to recommend an IPO as a prospective investment for a client?" asks Kevin Gahagan, principal at Mosaic Financial Partners Inc. in San Francisco. "I can't think of a particularly compelling rationale. Particularly in light of the data relating to the [lack of] success of IPOs several years out, and using those statistics as a reasonable guideline, we conclude you're betting against the house by getting into the IPO market."
But not all IPOs are created equal, and it seems that size-and fundamentals-matter. University of Florida professor Jay Ritter, a noted IPO researcher, finds that IPOs with annual sales of less than $50 million severely underperform, while those with annual sales north of $50 million don't.
Schuster says investors in the U.S. market would've been well-served in recent years if they focused on the IPOs of larger, profitable companies such as Visa, MasterCard, Google, Dollar General and CME Group.
The chronic underperformance of newly minted public companies is kind of a natural selection process," Schuster says. As a result, he adds, it's difficult for individual investors to successfully play the IPO game.
Schuster's Chicago-based company, IPOX Schuster, has created a range of global indexes based on IPOs and spin-offs. His IPO indexes hold companies up to four years, with quarterly rebalancing aimed at jettisoning underperforming companies and keeping the better performers.
"I think the ideal format for capturing the alpha in underpricing is a pooled interest in a larger fund format," Schuster says. "If you have a solid index methodology around it, you can get some solid returns."
Year Of The Automobile
As of early September, the top ten U.S. market IPOs from the prior 12 months were split between companies from the U.S. (five) and emerging markets (four Chinese and one Indian). Among the year's successful IPOs are recognizable names such as the Vitamin Shoppe (up nearly 50%) and Dollar General (up almost 37%).
Two companies of particular interest to financial advisors have logged low-double-digit gains since going public this year. One is Envestnet, a provider of wealth management services to the advisory industry. The other is Financial Engines, a company co-founded by William Sharpe that provides online financial advice and manages retirement funds in employer-sponsored retirement plans. In June, the parent company of LPL Financial Corp. also announced its plan to go public.
But there have been plenty of dogs among this year's IPOs, with the worst 15 or so down at least 30%.
Bill Buhr, Morningstar's IPO strategist, believes last year's IPO class contained a number of solid companies with profits and little debt. One example he cites is baby food maker Mead Johnson Nutrition Co., which debuted in February last year and recently traded at around $52, or double its first-day closing price.
But on the whole, Buhr finds the Class of '10 wanting. "We're seeing a lot of lesser companies trying to get deals done before the IPO window closes again, given the uncertain economic conditions," he says. "That's why we're seeing more deals being priced below their offering range."
Buhr points to Tesla Motors-the Palo Alto, Calif., company that makes the sporty Roadster electric vehicle and is one part Silicon Valley tech business and one part automaker-as a poster child for this year's IPO market. As the hype surrounding its late-June stock offering grew, the offering price rose to $17 from an expected range of $14 to $16 and the share count was boosted to meet demand. The stock shot up 41% on its first trading day, to $23.89. It peaked at $30.42 shortly afterward, and eventually drifted below its $17 offering price. It recently traded at more than $20.
To some observers, Tesla's offering harks back to the IPO frenzy of the tech bubble, when investors went gaga over unprofitable companies with more sizzle than substance. Tesla plugs into the green technology craze, was co-founded by the co-founder of PayPal, and counts Brad Pitt and George Clooney among its customers.
But the company's financials tell a different story. "They're not making any money and will probably have to raise more money at some point," says Buhr. "In reality, this is a speculative, long-term story."
As for General Motors' pending IPO, Buhr says Morningstar's early take is positive. The company took advantage of its bankruptcy period to jettison its weakest brands and slash most of its gargantuan $95 billion debt. "We think it's a clean company focused on its best products, and it's an intriguing IPO," he says.
GM is an unusual case: Once one of the paragons of U.S. industrial might (symbolized by the famous-and misquoted-saying, "What's good for General Motors is good for America,"), the company filed for bankruptcy 16 months ago and is now a ward of Uncle Sam. Its IPO will give it a chance to re-enter the womb and be born again in the public market.
A Renaissance Capital report on GM's IPO says a few things must happen to ensure a successful offering. For one, both the company and the U.S. Treasury Department-steward of the federal government's 61% stake in GM-need to clearly define the government's future role, because even if GM raises $20 billion, the IPO won't be big enough for the government to cash out and get its money back.
At the same time, the report says, GM is similar to a debt-laden private equity company with backers eager to monetize an investment and willing to sell at discounts to unload their shares. "It is crucial for the new public shareholders to make money on the IPO," the report reads, "because an IPO that trades below its offer price often becomes a broken stock, avoided by investors."
Why-And How-To Play
Every public company begins as an IPO, but many investors would rather skip the toddler stage and wait until the companies grow up.
"We want a high degree of probability of achieving an end result," says John Henry McDonald, president of Austin Asset Management Co. in Austin, Texas. "An IPO is an initial public offering, and I can't say anything about what the probability is of that thing doing well over time."
In July, Renaissance Capital issued a white paper attempting to debunk some of the negative notions many investors-including such well-known critics as Wharton professor Jeremy Siegel-have about IPOs.
The FTSE Renaissance IPO Composite Index, says Renaissance, suggests that IPOs have outperformed both the S&P 500 and the Russell 3000 in four of the six years from 2004 through 2009. And Renaissance Capital says that despite the inherent volatility of IPOs, its IPO index has produced better risk-adjusted returns than the other two indexes from 2006 through this year's second quarter.
The report says the upside allure is that some IPO companies have disruptive technologies and business models that challenge the status quo and offer game-changing opportunities that can enable active money managers to generate alpha.
Investors interested in the alpha potential but scared of the beta reality of IPOs can go the fund route, such as the Direxion Global Long/Short IPO fund (DXIIX) or the IPO Plus Aftermarket Fund (IPOSX), advised by Renaissance Capital.
For people willing to invest directly in individual IPOs, the pipeline could soon hold some interesting companies such as LinkedIn and Facebook-both rumored to be weighing the option to go public.
Josef Schuster from IPOX Schuster says shares of a Japanese social networking company called Gree Inc. have soared on the Tokyo exchange since the company's IPO in late 2008. "That's why Facebook's value on the pre-IPO market has shot up," he says.
A recent Morningstar report on IPOs identified a couple of companies with sound business prospects that could price in coming months. One is Iron Planet (IRON), an online auction for used construction and agricultural equipment. Another is Telx Group (TELX), a company that enables customers to connect to a diverse range of communications networks.
Still, when it comes to playing individual IPOs, Morningstar analyst Buhr's recommendation is to sit them out and wait for the stock price to fall in the aftermarket-because they almost always do, at least to some degree. Even after the legendary Google offering, the company's shares waffled and dipped slightly in the first couple of weeks as a publicly traded stock before they shot up.
"Find companies that you like, try to figure out what it's worth on a p/e multiple or discounted cash-flow basis, and then get in when it trades down to what you think is a good entry price," Buhr says.