How to spot a winning IPO, we backtest some stocks

Retail investors looking to cash in on the burgeoning Australian IPO market are constantly warned of the dangers of jumping on board without reading the Investment Prospectus of a company they are considering.  Professional analysts have the time and are paid to wade through a weighty prospectus as part of their jobs.  Consequently far too many average investors ignore the Investment Prospectus in the mistaken belief it is necessary to read the document in its entirety to glean any investing advantage.

It is not necessary to read the entire Prospectus word for word to answer the critical questions investors need to ask.  Here are the most important:

1.    What does the company do to make money?

2.    How many customers need what the company provides?

3.    What other companies provide the same or similar products or services?

4.    Why is the company choosing to go public?

5.    How will the funds raised from the IPO be used?

6.    Who stands to benefit from the IPO?

7.    How will the company grow in the future?

8.    What could go wrong?

In the last 18 months Australian investors have been deluged with companies going public.  As one might expect, some have been remained successful in terms of share price while others have not.  An interesting question for retail investors who either picked losers or avoided winners is were there any clues portending the future to be found in the initial Investment Prospectus.

Backtesting is a time-honored method used by technical analysts and traders.   While certainly not the stuff of rocket science, we believe that reflecting back on an Investment Prospectus can spot hints of what might have been to come.

So where does one begin to look?  Although total page count varies from company to company, the outline of an Investment Prospectus is fairly standard, with the following sections in most:

•    Investment Overview

•    Industry Overview

•    Company overview

•    Financial Information

•    Risks

•    Key people, interests and benefits

•    Details of the Offer

•    Investigating Accountant’s Report

•    Additional information

In the vast majority of cases, the basic details you need to answer the investing questions posed above can be found in the Investment Overview section.  Additional specifics are provided in later sections.  In theory then, one could “research” an IPO from an intelligent reading of the Investment Overview section.  In practice, the additional information in later sections can be informative and helpful.  We are going to look back into some highlights in the Investment Prospectus of four companies that debuted on the ASX within the last 18 months.  Here is the table.

While Internet insurance selection portal ISelect (ISU) was getting its share of pre-IPO hype; investors in little known micro-cap Indoor Skydive Australia (IDX) have reaped the rewards.  The following price chart comparing the performance of the two tells the tale.

How can this be?  After all, how many people are interested in skydiving?  Given the fact Skydive had yet to build its facility much less earn a dime at the time of its IPO, why would anyone but mad dogs and punters invest in this stock?

The Investment Overview section of the Skydive Prospectus tells us the company has exclusive rights to VWT (Vertical Wind Tunnel) technology with which it planned to build Australia’s first indoor skydiving simulator.   Future growth could come from the construction of additional facilities in areas identified in the prospectus.  In the Industry Overview section we learn In Australia has more than 100,000 registered skydivers that log more than 310,000 jumps per year.  In addition, the Australian military has more than 800 positions requiring skydiving training.

Yet if you compare the money-making potential of IDX against the much larger market for ISU, one would be hard-pressed to say why the dramatic difference in share price between the two, both initially and over time.

One possible explanation was readily available in the prospectus of both companies regarding how the companies planned to use the proceeds from the IPO.  Skydive Australia listed cash payments for vendors; operating costs; the costs of the IPO; and contributions to operating capital.  Note that the primary purpose as stated in the prospectus was organic growth.

In contrast, ISelect offered three reasons for going public – to provide funding flexibility to support future growth, including by acquisition; to raise capital to strengthen the Company’s balance sheet and pay down debt; and to create liquidity in ISelect Shares by listing on the ASX which will allow existing and new shareholders to sell their shares or buy further shares on market.  The relevant purpose here is the creation of a vehicle that would benefit pre-IPO shareholders with the ability to sell their shares.

Retail investors familiar with what happened to the ill-fated debut of Myer Holdings (MYR) who took the time to read the prospectus should have seen a red flag here.  The Offer Details for ISU stated there were about 143 million shares held at the time of the IPO, with close to 20 million held by Spectrum Equity.  Approximately 116 million additional shares would be issued in the offering.

When Myer went public US private equity firms TPG and Blum Capital held 81% of the existing shares, which they sold.  Most IPO’s now include in the Investment Prospectus how many existing shares will be held in voluntary escrow, prohibiting sale until a future date, usually the first release of Full Year Financials.  The ISelect Offer Details told those who bothered to read them that of the 143 million existing shares only 32 million would be held in escrow until the release of Half Year Results, with another 36 million held in escrow until the release of Full Year Results.  The red flag here is the more than 50% of existing shares that could be traded within six months to a year following the IPO.  In fact, Spectrum Equity sold the majority of its stake on the first trading day, with other existing shareholders selling shortly thereafter.

Skydive Australia had 28 million existing shares, a portion of which are to be held in escrow for two years, and issued 60 million shares in the IPO.  ISelect has been beset by other problems, not the least of which has been resignations of key operating officers.  However this is a risk factor included in the Investment Prospectus of many IPO’s.  With a history of financial performance as a privately held company, the prospectus for ISU contained revenue and profit forecasts as well as historical performance.  Every Investment Prospectus is filled with warnings about forward looking statements and declarations that forecasts might not be met, yet the ASIC later conducted an inquiry into the disparity between the ISU forecasts and actual results reached later.  ISelect was cleared and may still have a bright future.  Indoor Skydive may yet fail, but the potentially negative impacts of existing shareholders selling out and the positive impact of IPO revenue committed to growth were there for all to see in the Investment Prospectus.

The final two shares in the table are both from the healthcare sector, with Virtus Health Limited (VRT) showing relatively strong share price performance since its debut while Japara Healthcare Limited (JHC) has been less than impressive.  Here is the price movement chart comparing the two.

Were there any clues in the Investment Prospectus of the two companies?  From the Company Overview Section we learn that Virtus Health has three revenue streams – assisted reproductive services (accounting for 77% of current revenue); specialised diagnostic services; and private day hospitals.  The company’s growth plans call for expansion in all three.

From the Offer Details section we learn that the existing 19.9 million shares are held by fertility specialists, scientists, and company employees with 16 million of those shares to be placed in voluntary escrow.  Two million shares were released from escrow on 13 August, with no negative impact on the share price.  The absence of existing owners ready to cash out after a successful launch was important information readily available in the prospectus.

Many investors would have been justifiably concerned about the growth prospects of reproductive services.  The Company Overview lists the company’s plans to increase its already dominant market position here and more importantly, outlines a growth strategy for the two revenue streams likely to benefit from an aging population – specialised diagnostics and private day hospitals.

Healthcare is a booming industry and subject to increasing competition.  In addition, the spectre of government regulation looms large.  Many analysts caution investors about the glowing prose in an Investment Prospectus for future prospects.  The Risks section is frequently dark in tone, listing every possible thing that could go wrong.  Investors need to know how much government funding a new healthcare float receives and the likelihood of changing circumstances.

On the competition front, a Virtus competitor, Monash IVF Group (MVF) went public on 26 June 2014 and the share price was on the rise until the Australian Financial Review and others reported that a former advisor to Tony Abbott is suggesting limits to government funding of reproductive medicine, sending the shares of both companies tumbling.  Here is a one month movement chart for Virtus and Monash.

In addition, on 13 August Primary Health Care (PRY) issued a press release announcing that 1,200 patients had already received treatment at the company’s IVF (In Vitro Fertilization) Clinic, opened in July in Sydney.

Investors salivating over the long term trend of an aging population with longer life expectancies may have jumped into residential aged care and retirement village provider Japara Healthcare Limited (JHC) without checking the Investment Prospectus.  Had they done so, they would have found in the Risk Section the following statement:

•    The Australian aged care industry is highly regulated by the Government. From 1 July 2014, the Government changes to the aged care regulatory framework will commence (see Section 2.4 for more details).

•    Any further future regulatory change for the industry may have an adverse impact on the way Japara promotes, manages, and operates its facilities, and its financial performance.

It should have come as no surprise to investors when the shares went into a trading halt following the announcement the federal government would cut payroll supplements paid to commercial aged care providers from July, 2015.  The share price took another hit on 26 June when the market learned the government would cut dementia supplements commencing on 1 July 2014.  Here is a price chart for JHC showing the moves.

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