Initial Public Offerings

Investors warned

Initial Public Offerings
Initial-Public-Offerings.jpg
One of the investment opportunities that is always guaranteed to get pulses racing amongst both retail and institutional investors is the chance to invest in an Initial Public Offering (IPO).

An IPO is the first sale of shares by a private company to the public. IPOs are often issued by smaller, younger companies seeking the capital to expand, but can also be done by large privately owned companies looking to become publicly traded.

According to Wilhelm Hertzog, portfolio manager at RE:CM, while the chance to “get in at the ground floor” of a “dynamic company” with “great potential” may be an extremely enticing prospect for many investors, there is ample evidence, both globally and in South Africa, that shares bought in an IPO underperform the market substantially over long time periods.

Research by Govindasamy (2010) to determine the long run (three years) performance of IPOs listed on the Johannesburg Stock Exchange JSE in South Africa between 1995 and 2006,found that IPOs underperformed the JSE by 50% and 47% on an Abnormal Return (BHAR) and Cumulative Abnormal Return (CAR) basis respectively.

“In an IPO, one typically has a situation where informed insiders are selling to the less informed public,” says Hertzog. “The incentive is for the sellers to maximise the proceeds from the sale of the shares, which means that the IPO price is unlikely to represent attractive long term value for a buyer of those shares.  The investment odds are stacked heavily against the buyer.”

He says that in particular, investors should be wary of participating in IPOs in sectors where a large number of IPOs are taking place.  “IPOs tend to happen in sectors where stock prices are above intrinsic value due to short term optimism towards the sector.  The most recent example of that was the local construction sector around 2006/7.”

Hertzog says that currently, the listed property sector in South Africa is attracting a large number of IPOs, which should be considered a warning signal. “With the global reach for yield that is currently happening, the local listed property sector’s share prices have been driven up to generally unattractive levels.  We would urge caution for anyone considering an investment in the sector, and even more so for a new listing in the sector.

“Globally, there has been a preponderance of IPOs in emerging markets, with Hong Kong being the leading market for new listings in 2011.  We are steering well clear of those markets in general, and new listings in those markets in particular.”

According to Hertzog, deciding whether an IPO offers value involves the same process of valuing a business as one should engage in prior to deciding whether the shares of any other business offers value.  What complicates matters is that typically there is a limited amount of financial history available for a company coming to the market in an IPO, which can make it more difficult to establish the long term economics of the business at hand.  This makes it more difficult to estimate intrinsic value with any degree of accuracy.

He says there are numerous examples of IPOs that did not benefit investors, with a number of examples from the construction sector listings boom in 2006/7. “The example that has been attracting the most media attention lately is probably Sanyati, which went into liquidation recently.  Globally, investors in Facebook’s IPO have had disappointing results to date, but we would consider the time since Facebook’s listing to be too short to draw any real conclusions about the benefit to investors.”

However, he says there are some IPOs that stand out as exceptions to the rule, such as Google, whose IPO at the time was probably as eagerly anticipated and as “hot” as that of Facebook recently. “In contrast to most IPO’s however, the Google IPO greatly benefitted long term investors in the share who bought at the time of its IPO.  The business has delivered financial results that have met and exceeded the high expectations reflected in the share price at the time of its IPO.”

Locally, he says that an IPO where investors did exceptionally well was that of Eland Platinum.  The company listed early in 2006 and was bought out by mining giant Xstrata for almost five times the IPO price less than two years later.  

“In hindsight, there is little doubt that Xstrata overpaid for the company, and that the phenomenal returns achieved by the IPO investors was more due to another investor coming along and offering a ridiculous price for their shares than it was due to the underlying performance of the Eland Platinum business.  But that investors in the IPO benefitted greatly is undisputable.”

Hertzog says the reason why investors invest in IPOs, and experience the disappointing longer term returns that typically follow, is not as a result of a lack of regulation, disclosure or transparency.  “Investors invest in IPOs because of the positive sentiment towards sectors in which IPOs typically happen, the usually rosy short term prospects for a company coming to the market. 

The emotional comfort and sense of satisfaction of investing in the topic of dinner conversation, and the prospect of gaining from the first day “pop” that IPO shares often experience. Unfortunately, regulation is powerless to prevent these conditions from forming, and will have to be able to protect investors against themselves if it is to have any real impact.”

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