How to Profit from the Resurgence of the IPO
During the technology boom and bust of a few years ago, initial public offerings (IPO's) were on the tip of the tongue of almost every investor and financial professional I met.
And why not? The peak of the IPO craze was 1999, when 486 deals were completed, raising $93 billion for newly public companies. 2005's 234 deals, for a grand total of $36.8 billion, hardly rate a comparison to those numbers. But considering the lackluster years of 2001 (83 IPO's), 2002 (70 IPO's), and 2003 (68 IPO's), the resurgence in 2004 (216 IPO's), followed by 2005's performance gave credence to a revived IPO market.
And 2006 has cemented the trend.
So far this year, 172 new deals, worth some $40.1 billion, have come to market. And currently, there are 6 deals scheduled for this week and another 14 for next week.
How the market has changed since the record deals in 1999. Back then, almost all IPO's were cutting-edge technology companies, few with any actual earnings or even foreseeable future earnings. In comparison, last year's issues were made up of companies that, for the most part, actually made money, and in widely-diverse industries. Health care and financial services sectors led the way, each accounting for 17% of all IPO's completed, followed by technology at 15.5%.
Thus far, in 2006, health care remains on top, at 20%, followed by energy (16%), financials (15%) and technology (15%).
We are currently seeing more small- to mid-cap companies (some of my favorite categories) move into the IPO market. With more to come. The SEC has a backlog of 130 deals, worth some $18.2 billion, filed and raring to go. And market soothsayers believe that with the Fed's changed stance on interest rates, the IPO market may find even greater life in 2007.
While I love the idea of new companies coming to market - vastly expanding our universe of profitable opportunities - I still remain skeptical of the average investor leaping into IPO's.
Don't get me wrong - I am definitely a believer in IPO's. Heck, without them, Microsoft, GM, IBM, and thousands of other blue chip companies would not be the behemoths they are today. IPO's are the very foundation of our investing system.
But the hypester promoters - and the gullible investing public - gave IPO's a black eye in the late 90's, early 2000's - and with some of the new and recent IPO's coming downstream, it looks like they have not completely disappeared. Take Vonage (VG: NYSE), for example. The telecom company has never been profitable. Yet its 2006 IPO was hyped to the gills, raising $531 million, with the shares debuting at $17. Currently, those same shares are trading at $6+.
This is a perfect example of buyer beware. As the IPO market heats up, investors will have to be very careful in avoiding buying shares in those companies that have no business selling stock to the public - businesses with no profits and esoteric products that I couldn't explain to my smartest friends, let alone my elderly relatives.
The Pros and Cons of IPO's
Let me back up a minute and tell you what IPO's are supposed to be and do.
Companies issue stock for a couple of reasons: One, the founding family of a business - for any number of reasons - the founder dies, decides to retire, just gets tired of working that hard - desires to get out of the business. And selling the company publicly is one way to collect the fruits of their hard labor.
But the more likely scenario is this: Successful entrepreneurs often find that the needs of their businesses have outgrown their personal financial assets. Consequently, if they want to remain competitive in their industry, they must expand. Or they die. Therefore, the number one driving force behind IPO's actually is to raise capital to expand a business.
Yep, that's right. The stock market was and is meant to be an exchange of cash for stock, with a long-range plan. Investors turn their hard-earned cash over to well-run businesses who want to grow. In return, investors hope to get their money back, plus a profit - over a period of time. Not overnight.
Unfortunately, it's not only novice and greedy investors who may be taken aback by that statement. Why? Because Wall Street has conned unwitting investors, millions of decent people, into buying into their theory that IPO's are a get-rich-quick-scheme - for the lucky few.
They couldn't be more wrong. Except, of course, that for Wall Street execs, their largest clients and even some politicians, it does usually work out that way. But for everyday people - the bulk of investors in this country - the story is not quite so sweet. In fact, I can count on one hand the number of individual investors that I personally know who have made a killing in the IPO market. And just a few more actually were actually able to get their hands on IPO stock at the offering. And I bet you can say the same thing.
So, forget about easy money. Instead, think about investing in companies that make a real product, that have the potential to grow their businesses with double-digit returns - in the foreseeable future.
And forget about getting into an IPO when the company first becomes publicly-traded. Unless you are a well-heeled big brokerage client, or someone with political connections, the only IPO's you are going to be invited to buy will be dogs. Take my word for it.
But that's not to say that you can't profit from IPO's. Just let the companies go public, and then bide your time. Be selective, look at the numbers, and see if their product makes sense. After the first couple of public quarterly reports, take a close look at the companies, evaluate them from the standpoint of how well they will fit into your personal investing strategy and portfolio, and then buy the ones that look to have long-term favorable potential.
Separating the Winners from the Losers
So, how do you evaluate a newly-public company? Why, almost the same way you value any company:
Do you understand what the company does? This should actually be the first question you ask yourself. If the answer is no, just stop right there. Too many fortunes were lost in the dot.com craze, when investors believed everything they were told, and didn't have a clue as to what the company actually did, what products it made, or how it would ever make money.
How does a company compare to its peers on its most basic financial criteria?
- Price-earnings ratio
- Price/sales
- Debt/equity
- Operating cash flow growth (and make sure cash flow is positive!)
- Historical sales growth
- Historical earnings growth
Are executive salaries reasonable? Compare the salaries of the executives to others in their industry. And also compare them to the company's sales and earnings. Do the numbers make sense? If a company is only earning $2 million a year and it's paying its CEO $1 million, that just doesn't compute!
What market share does the company enjoy? I love investing in companies with the number 2 or 3 market share position - so they have something to shoot for - overtaking #1. And while you may think newly-public companies would not be in that enviable of a position, sometimes they are. They may have been doing business for 50 years, and just decided to sell their shares to the public.
Is its industry in a growth mode? It matters not if the company is wonderful, if it is selling its products in a stagnant sector.
Is the company a one-product firm, or is it diversified? Diversification of products and product lines mitigates the risk of one sector declining and taking the company down. In other words, it's like my father always said, "Don't put all your eggs in one basket."
Does the company depend too much on one big customer or one large supplier? Again, diversification is smart.
The biggest obstacle you will find is lack of data. If the IPO company hasn't been in business long enough to create a substantial track record, you must improvise, by extrapolating industry data and projecting how closely your company might track its peers.
You can consult www.reuters.com, Comparison Ratios, and find out the average industry ratios for most of the above financial criteria. Additionally, you should take a look at other recent IPO's for your selected industry, and find out the gain or loss on the price of their shares since the IPO. The Securities and Exchange Commission (SEC) has a great web-site for gathering this sort of data. It is: http://ipoportal.edgar-online.com/ipo/home.asp.
Then, it's up to you to determine if this company presents a compelling picture for buying its shares. But please, heed this warning: Be very careful. Even if you buy after the initial public offering has settled in, IPO's are still speculative, with little or no public trading history. So, even if you do decide to take a gander, make sure IPO's are relegated to a very small portion of your portfolio.
As always, only you can determine if the stocks you research are a fit for your personal investment requirements. Let me again caution you that IPO stocks are not for the feint of heart. With that caveat in mind, I wish you happy hunting.
About the Author
Nancy Zambell, Contributing Editor to BrokerAdviser.com's Financially Fit, has enjoyed a diversified career in the financial services industry.
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