There is a certain predictability about Initial Public Offerings. As the sharemarket rises, corporate advisers talk up the prospect of a wave of them. Fund managers, in turn, warn about the risk of overpriced IPOs and poor-quality businesses being dumped on investors.
Both arguments are understandable. Sellers (vendors and their advisers) talk up the IPO market to get the best price, and buyers (fund managers) hose it down to encourage more reasonable valuations. As always, the answer is somewhere in between, with one caveat: the sharemarket.
Expect a rush of fourth-quarter floats if the Australian sharemarket gets through the latest bout of jitters about the US debt ceiling and the S&P/ASX 200 index stays above 5,000 points. A market heading towards 5,500 points by December, as some strategists predict, would be ideal timing.
But watch for mooted fourth-quarter floats to be pulled or deferred to the second quarter of 2014 if sharemarket falls in the last few days turn into a bigger pullback and even a 10 per cent correction. This column has warned about the risk of a sharemarket sell-off in September or October for several weeks and suggested reducing exposure to Australian and global equities during this period.
It is a nervous time for IPOs. Those seeking to list by year’s end need to approve a float within a few weeks, given most take at least three months to conclude. Failure to list by Christmas, and thus not reaching investors over the holidays, means waiting until after the February interim-profit season.
I’m betting on the local sharemarket losing ground in the new few weeks, but staying above 5,000 points and then having a Christmas rally. If that scenario plays out, watch for six to eight decent-sized IPOs by December and even a few that spill over into the New Year.
More than $6 billion could be raised in the fourth quarter from IPOs of New Zealand electricity privatisation Meridian Energy, OzForex and McAleese Transport, and expected floats of Nine Entertainment Co, Fife Capital Industrial REIT, Dick Smith Investments, education group Vocation, Redcape Hotel Group, and credit-reporting company Veda.
With $3.4 billion already raised this year, mostly from the Mighty River Power, Virtus Health, iSelect, Steadfast Group and Z Energy offers, the IPO market could raise more than $10 billion and have one of its best years, after the worst year in more than a decade in 2012.
The IPO pipeline is swelling for several reasons. First, after being mostly blocked for five years since the 2008 Global Financial Crisis, there is huge pent-up demand for companies to raise capital and list. My guess is people are underestimating just how many capital-seeking companies have been itching to float for years.
Another supply driver is capital-raising competition. Many companies have run IPO and trade-sale processes in parallel in recent years to test the market and corporate appetite to buy assets, and create price tension. Often, assets have been sold via trade sales to other companies, rather than IPO.
That dynamic appears to be changing. A higher sharemarket may have led to IPO valuations running ahead of trade-sale valuations, incentivising vendors to test the sharemarket rather than sell to another company. The result is more assets making it to IPO.
Another IPO supply driver is relative valuations. Sharemarket valuations, particularly for small and mid-size industrial companies, look frothy. The Small Industrial index, for example, now trades at parity to the All Industrial index, based on an average Price Earnings (PE) multiple, even though smaller stocks should trade at a discount because they have less liquidity and usually weaker franchises.
Fund managers struggling to find value in small- and mid-cap stocks – or extra “alpha” (a return above the market return) – should be attracted to IPOs they perceive have been offered at a discount to their intrinsic value. For the first time in years, the demand-side (institutional investors) is showing more sustained interest in floats.
The other supply driver is cash. There are huge amounts of it on the sidelines that can be deployed into growth assets such as shares. Self-Managed Superannuation Funds (SMSFs) alone had $154 billion in cash and term deposits at June 2013, Australian Tax Office data shows.
However, investors have good reason to be wary of IPOs. There have been several shockers in the past five years, notably the early post-listing disappointments of Myer Holdings and Kathmandu Holdings and Miclyn Express Offshore, the disappointing Collins Food IPO and, more recently, the troubled iSelect float.
Fund managers, with good reason, remain wary of private-equity-vended assets dressed up for a quick IPO and sold on aggressive valuations. Already there is talk of IPOs being offered on high PE multiples or at a slim discount to established peer companies.
Seasoned investors know IPO booms often lead to poor-quality assets being offered at inflated prices to cash in on strong sentiment. After a few years of slow markets for corporate advisers, there will be no shortage of broking firms wanting to float assets and earn big fees.
My view is simple: investors need to assess each IPO on its merits, compare its valuation with its nearest listed peers, and have a strong reason to buy stock in a float rather than in an established listed company. IPOs have higher risk, so should be offered at a discount to compensate investors. Always ask: why are vendors selling?
That said, this is an interesting stage of the cycle for IPOs. The sharemarket appears to be in the second stage of a bull market – expectations of rising company earnings – and far from the final phase of rampant speculation, when so many dodgy floats emerge.
Experience shows better-quality assets usually come to market earlier in the IPO cycle. If, like me, you expect the Australian sharemarket to head towards 5,500-6,000 points in 2014, in anticipation of an improving economy, this could a reasonable time to buy IPOs of good businesses.
But, as always, it depends on price and asset quality. The key is to think like a business owner and ask whether you are able to buy shares in an IPO at a sufficiently large enough discount to your valuation of the company to provide a decent safety of margin.
It’s also worth noting that the vast majority of floats in the past five years have traded below their issue price a year or two after listing. Often, the best value is found when the IPO falls under its issue price and the market gives up on it, meaning there is no huge need to rush for floats in this market.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at Oct 3, 2013.
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