After a long drought>, initial public offerings are making a comeback.
There are six possible IPOs on the docket for this week. Half of them are technology companies, including national security specialist Global Defense, medical record firm HealthPort, and computer network security company Fortinet. Then, there are coal mining company Cloud Peak Energy, budget hotel chain 7 Days Group Holdings and online education provider Archipelago Learning. They are diverse, but what s more remarkable for Wall Street is just how many of them there are. If each launches as scheduled, investors will see the most IPOs in a single week since December 2007, The Wall Street Journal reported. But what are they supposed to do with them?
As more capital becomes available for these young companies to enter the market, the question for investors is whether they are good long-term investments or just fodder for day trading.
IPOs by American companies have beaten the S&P 500 by an average 21.3 percentage points since 1995, according to a Bloomberg report, but these investments haven t outperformed lately. The offerings of 18 U.S. companies that went public in September and October have underperformed the S&P 500 by 0.4 percentage point on average in the first month of trading, the worst performance in Bloomberg data going back 14 years, according to the report.
For the individual investor, IPOs can be a risky bet. There s a bounce for a while, but it s more of a trade, says Doug Roberts, chief investment strategist at ChannelCapitalResearch.com. There are always exceptions, but if you look long term, they re not always positive. People start liquidating, and unless you re in a hot bull market, they don t perform as well.
IPOs tend to be growth stocks, or companies whose earnings are expected to grow at an above-average rate relative to the market, but historically, many have suffered from lower returns relative to value stocks, says Jay Ritter, a finance professor at the University of Florida. Now, the current crop this year has a lot of buyout-backed IPOs, and those tend to be more mature companies that typically aren t selling at lofty multiples. In that regard, this year s class is more conservative compared to the past, particularly to the 90s, he says.
Since it s not part of the froth of a couple years back, the successful IPOs are those that are being properly and fairly priced, says David Stone, head of the Corporate and Securities Practice Group at Neal Gerber Eisenberg. So if the issuers aren t too aggressive and provide some value for investors to see, those are the ones that are currently having successful launches.
Whether they re from private equity funds that are looking to monetize or provide liquidity in their investment, or you ve got a strong stable company with a long history, you are seeing some quality investments, he says.
At least throughout this year so far, that s what I would consider the primary theme of the successful IPOs, he says. Overall, you re now starting to see some more rationality, whether it s in IPOs or M&A, valuations are starting to come down to more reasonable and sustainable levels.
Obviously a lot of this has to do with valuations, which have changed drastically. The main procedure used to price offerings is comparable firm valuation, or comparing the new firm to similar companies that are already public, accounting for differences, and hitting the road to tout your story and gauge interest.
Normally, IPOs are priced with a slight discount so there s a bit of a pop upon offering, says Roberts. They want it to be reasonable enough that those that bought into the initial offer feel a cushion.
Day One Fireworks
Prices can be tweaked up to nearly the last minute, and rising prices create more fanfare. Traders saw that phenomenon last week when teen retailer Rue21 priced above its expected range and went on to shoot up 28%.
In the short run, yes, those [launches] where they increased the offer price are much more likely to have a high first-day return, which for an investor makes it kind of strange, says Ritter. The more the price is increased, the more likely it is that there will be a first day profit for investors, in part because they re increasing the price after finding stronger demand.
Small IPOs sometimes fall prey to market manipulation on the first day; a first day with a high return is usually associated with low long-run performance. 2) The other exception came during the tech bubble period 10 years ago, in which larger first-day returns hinted at a more likely collapse.
As with all stocks, there is a value vs. growth relationship, where companies that are being priced at a very high multiple disproportionately end up disappointing investors, whereas those priced at more conservative multiples are less likely to disappoint, says Ritter. On average, value stocks beat growth stocks.
Rewind 10 years and consider stocks like Internet grocer and home-delivery company Webvan.com and Pets.com, which went bust within a year, Ritter says.
That s when you have to ask yourself, Is there a potentially large market? Are there advantages of being the first mover or barriers to entry that might not allow a company to earn more than a competitive rate of return? he says.
Classic exceptions that have been able to earn a high return on equity and a high profit margin are Google and Microsoft, he says. On the other hand, non-tech companies have been able to expand and earn above-competitive returns most notably Starbucks, Wal-Mart, and McDonald's. In Wal-Mart s case, they accomplished it with largely superior logistics, and in Starbucks case, they ve got a reputation for high-quality products, he says.
That often comes out in the description of the business and on the road show presentation, which is usually available to individual investors, when the company is describing what makes it special, Ritter says. It s in those materials where they explain how they plan to outperform.
Of course, none of them are going to say we re just run of the mill, and there s no reason to think that we ll just pull out of the pack , says Ritter. They ll tell you what can go right. What can go wrong is in the risk factor section.