Are IPOs a worthwhile investment?

Welcome to Finance and Fury. In this episode we will be looking at investing in IPOs and if this can be a strategy for sustainable above market returns – or if this is simply a capital trap for investors – lots to unpack, as we will go through what IPOs are, why companies list, why investors purchase them and how they have performed.

This episodes content is no advice but a general discussion on how IPOs have performed in the past

To start with – What is an IPO?

1. An initial public offering (IPO) is the process when a private company offers its shares to the public through a new listing on the share market.
   1. This process essentially is the transition of a private company into a public company – in other words, a company that an insider group of individuals own to one that anyone can own
   2. This whole process is completed to allow the company to raise capital by selling its shares on an open market
      1. It also allows the existing shareholders to make an instant return on their capital – depending on the list price
      2. This is where an IPO can be seen as an exit strategy for the company’s founders and early investors, realizing the full profit from their private investment
   3. But the major reason for IPOs is to provide companies with an opportunity to obtain capital by offering shares through the primary market
      1. the public market – people the share market – opens up a huge opportunity for millions of investors to buy shares in the company and contribute capital to a company’s shareholders’ equity – this can be used to fund a company’s expansion
      2. Say you have a private company – one that has a handful of investors – to raise additional funds, you would need to have these existing investors chip in more money to the company, issue and sell more shares to new investors, which existing investors may not be happy with – or take on debt – as the existing investors control the company through votes through the shares they own – raising capital can be limited as these investors may not want to dilute their capital holdings through issuing more shares, or taking on debts, reducing their profit margins

• However – if a company were to IPO – and the company is in demand – then a new share price can be set and these initial investors can sell part of their holdings on mass and make additional capital

1. When a company goes public, the previously owned private share ownership converts to public ownership, and the existing private shareholders’ shares become worth the public trading price – where they were previously only adjusted in valuation maybe once a year

2. To be eligible – Companies must meet requirements by the exchanges they are listing on to be eligible to list –
   1. I won’t go the full process here – but normally companies hire investment banks to market the IPO, gauge demand, set the IPO price and dates for listing
   2. Companies also need to meet certain requirements on their market caps and revenues – and have some history dating back at least 3 years
   3. IPOs normally occur once a company reaches a stage in its growth process where it believes it is mature enough for the rigor’s and costs of regulations along with the benefits and responsibilities to public shareholders
      1. A private company can technically list at any valuation – as long as it has strong fundamentals and proven profitability potential can also qualify for an IPO, depending on the market competition and their ability to meet listing requirements – plus it can cost a few million dollars to list – so this is the largest barrier to entry for smaller companies
   4. But what price do they offer their shares at – and how many shares do they sell?
      1. the number of shares the company sells and the price for which shares are listed are priced through underwriting due diligence by the investment bank that is hired to provide this service
         1. Most of the time this is called book building – this process involves a price discovery which has a focus on generating and recording investor demand for shares before arriving at an issue price
         2. If a company is already well known and you can market this to the public as a great investment – you can demand higher prices for the issue – as massive PEs –
            1. The SpaceX/Starlink IPO is a good example – massive recognition and will likely float at above its fair value
         3. If economic times are good, and investor demand for growth shares are high – this gives the company a greater ability to grow and expand than in any other market conditions
         4. The best example of this was in the dotcom bubble era of the late 90s – where any company claiming to have anything related to e-commerce or the internet was bought up massively at their IPO – regardless of if they had any revenues at all – where almost all of them did not – this was because of the easy gains that investors thought were obtainable through buying into what was perceived as the next big company – for it all to fall flat once the reality of the situation came to light
      2. This period of time aside – are IPOs a good investment for those that are purchasing the shares pre-IPO?
         1. This can be seen by how they perform – so let’s look at some examples in the ASX – looking back over the last few years of data
            1. 2018 – 91 IPOs – 1 year returns – 25 were positive and 66 were negative – 27%
            2. 2019 – 63 IPOs – 1 year returns – 28 were positive and 35 were negative – 44%

• 2020 – 72 IPOs – 1 year returns – were 33 positive and 39 were negative – 45%

1. 2021 – 103 IPOs – only been 6 months – 22 have been in the last 6 months – but of the other 81 – 1 year returns were 18 positive and 63 were negative

1. In each year – there were more negative returns than positive – and many of these companies lost 100% of their value through either delisting or going bankrupt
2. But say you purchase every IPO that occurred each year – and how does this compare to the ASX
   12. 2018 – –12.85% return is the average return for all IPOs – compared to the ASX return of -3.13%
   13. 2019 – 28% return is the average return for all IPOs – compared to the ASX return of 23%

• 2020 – 26% return is the average return for all IPOs – compared to the ASX return of 1.18%

1. Overall – The magnitudes are higher – on both positive and negative – but it would require you to buy every IPO – which averaged around 80 per year

5. This being said – there are some outliers in the bunch – As a few these companies have done very well – as an example let’s look at the best 1 year returns companies each year and see where they are still at
   1. 2021 – Global Lithium Resources (Gl1) – 820% over first 12 months – listed at $0.20 – then was $1.84 – Currently sitting at $1.20 up 273% since listing
   2. 2020 – Cettire (CTT) – 604% over first 12 months – listed at $0.50 – then was $3.52 – Currently sitting at $0.40 down 20% since listing
   3. 2019 – Uniti Group (UWL) – 524% over first 12 months – listed at $0.25 – then was $1.56 – Currently sitting at $4.94 up 2,600% since listing
   4. 2018 – Lowell Resources Fund (LRT) – 450% over first 12 months – listed at $0.83 – then was $4.60 – Currently sitting at $1.30 up 54% since listing

But at the same time – remember that 28 of the total companies listed were no longer in operation after being listed for 12 months – and the majority were at a lower price today than when they listed –

1. The why behind this needs to be broken down further as not all IPOs are built alike
   1. Some IPOS are well known companies with a long track record of providing a good or services and being profitable in the process – take CBA, TLS, or MediBank – when these were listed, they were all already household names – and the marketing was easy – there was high demand for these companies –
      1. In this case – there will often be an over subscription to the IPO – meaning that prices will pop in the first month –
   2. Now compare this to smaller companies that have little to no proof in the market and are running at a negative EPS at listing – difference is proof of concept and financials – if there are none, then the price can decline from the IPO rather quickly
      1. People will demand what is known or what they speculate to be a good investment – they will dump something that has an absolute loss potential – which many IPOs do have
   3. Well established companies – have safety behind them – but can act the exact same in their return profiles as what buying an existing company of the market can provide – in other words, they don’t have the same 600% 1 year returns that some IPOs can provide – but they are safer
      3. MPL listed at $2 in 2014 – today it is worth around $3.2 – but like many IPOS had its initial sell off period where after the first month the price rose to $2.5 but then dropped down to $2
   4. The behaviour of most IPOS is to go through a ramp period in the few days to months following the listing –
      2. MPL was up to $2.5 by Feb of 2015 – resulting in a 25% return in 3 months – but by the 6 month mark it was back to its retail offer price of $2 – but this company had legs behind it and has a positive return
   5. There are many IPOs which are not the case – if there are no earnings behind the company – and there are little to no future promise of earnings, then this is where the price collapse of a company can be easily seen
2. Risk involved – comes down to company specific and market at large – like any share – but this can be exacerbated by the larger market sentiment
   1. Company risks can be increased by systemic returns – such as how they overall returns for the IPOs are tracking is heavily linked to how the returns of the ASX at large are performing
   2. The best 1 year returns for IPOs were in years the ASX also had great returns – which is one thing to watch out for – most IPOs occur when markets are hot – i.e. overpriced – this is to take advantage of investor sentiment – as IPOs can demand higher prices when investors are demanding more shares – but this is also the period that sees some of the worst results – as when markets are overheated – they often see declining periods – or cooling periods soon after

Summary – IPOs can be a good investment if you are lucky and manage to pick the next winner – but this is a minority of the IPOs – you technically have better returns over the long term by picking red or black or a roulette table – but in the short term – the 1 year returns can be better than the ASX returns due to the time period that the market sentiment around IPOs afford them – a get in and get out situation –

1. I view IPOs like a golden ticket – you can buy 100 bars and one will give you a great result – the others not as much
2. Much of the success from IPOs comes down to the current market conditions and sentiment –
   1. Sentiment high = better probability
   2. Sentiment low = Probably worse result
3. I personally invest in managed funds that specialise in IPOs – to do the trading for me to get in and out of the ipos that they deem fit to purchase
4. The risk and time involved to review and constantly monitor IPOs is not worth it in my opinion
5. However – for risk taking individuals – if the market is positive, then buying up all IPOs has provided a positive return after 12 months historically above what the ASX has provided – but in negative years, this is not the case, as it is provided a negative return of greater magnitude