6 insider tips for buying into an initial public offering

If you’re going to put your hard earned cash into a company that's about to list on the Australian Stock Exchange, what markers should you be keeping an eye out for?

Over the long term, the stock market has outperformed time and time again

We are all investors, whether it’s through our super fund, property, or a stock portfolio. The question is: where should we invest our money?

Over the long term, the stock market has created significant value for investors – but should you be looking at blue chips, Exchange Traded Funds, or Initial Public Offerings (IPOs)?

In 2015, the ASX All Ords lost 4.3 per cent. The ASX50 (an index of the biggest 50 companies) lost 1.3 per cent. So-called ‘safe’ blue chips and large caps also fared badly: household names like BHP Billiton and NAB were down 33 and 9 per cent. Compare that to Initial Public Offerings, or IPOs, which were up 23 per cent on average!

The odds of a positive return on an IPO investment were better than two to one

In fact, the odds of a positive return on an IPO investment were much better than average; last year, 59 per cent of IPOs finished the year at a price higher than their listing price while 6 per cent held their ground.

The point for investors is that it’s not just a matter of what company you buy but when you buy it. In general, backing companies going public gives you the chance to get in on the ground floor. If you’re going to put your hard earned cash into a new float, what markers of a good investment should you be keeping an eye out for?

Here are six suggested tests that you should subject any new issue to that will hopefully put you on the plus side of the ledger when the new shares actually list on the ASX.

1. What are they going to use the money for?

Companies seek public listing to raise funds, and there should be a clear statement in the Prospectus about where the money will go. Certainly, some has to go to pay inventors for patents and to vendors for businesses. And in many cases good companies have run up debts bringing products to market. But when you have a look at the Prospectus, you need to see some information about how they will invest to generate or expand revenue, to increase the value of the shares you are buying.

Also, and importantly, keep a sharp lookout for anything that will benefit a third party, as occurs in some floats, and any fees being paid out to advisors and the like that seem excessive.

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An initial public offering is the first sale of stock by a private company to the public

2. Do you understand the product?

It is simple yet integral advice, and something to keep a close eye on when investing. Understanding the product may particularly be a headache when it comes to technology stocks and their love of acronyms (anyone for SaaS, PaaS, or IoT?) though their promoters are no longer selling and investors are no longer buying the ‘blue sky’ the way they did until the ‘tech wreck’ of 2000.

Promoters know that investors won’t fall for guff that makes their eyeballs throb, so if they have a good product they must explain it in simple terms.

The lesson here is that if you don’t understand it then remember – it’s not you, it’s them. The expectation that companies explain the product in clear and simple terms is basic and companies should be able to be clear in the prospectus about what the product is and why it matters.

Investment guru Warren Buffett always says if you can’t work out what it is doing, stay away, as lots of other people will have the same problem. He’s right.

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3. How big is the market for the product?

The size of the opportunity and the company’s ability to capture market share can make all the difference when it comes to shareholder returns. Keep in mind that the size of the market is only an estimate that is based on many assumptions. These assumptions need to pass the common sense test.

For instance, say a company is selling widgets and is targeting high-income households. Consider how likely high-income households are likely to buy widgets before accepting that the market size is equal to the number of high-income households.

Ask yourself, are there substitutes for their widgets? Is it a need or a want? Would the product be better off as a Main Street or High Street product? Do macro social, political, economic trends support the assumption that high-income households will want to buy widgets or not?

Estimating the size of the market is a ‘best endeavours’ sort of thing but like point two - if you don’t understand it or it doesn’t sit right, think twice.

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In an IPO, the issuer obtains the assistance of an underwriting firm, which helps it determine what type of security to issue (common or preferred), the best offering price and the time to bring it to market

4. Who is going to be running the company?

Companies are nothing but a group of people who you hope are working together for the benefit of shareholders so have a close look at the lists of people shown in the prospectus as directors and managers. The track record of those who are going to be in charge is vital. Do they have prior experience in the industry? How long have they been with the company?

How and how much are they being paid? How well rounded is the board? And, critically – do they have, so called, ‘skin in the game’? That is, is their financial success tied to that of the company?

Keep an eye out for the less obvious. For example, some small companies combine both roles in an executive chairman which saves money but leaves a lot of power with one person. Ask any of your friends who might know this person, and Google them. Do your due diligence on them, as the old phrase goes. One piece of negative press may be a blip or a misunderstanding but a clutch of negative articles in different publications may be a red flag.

5. How is the offer structured?

If the product passes the ‘smell test’, the size of the market looks promising, the management is experienced, and the fees paid to advisors are reasonable then it may look like a great opportunity all round.

But if the offer is structured so that outstanding options will be automatically issued to the seller at a future date based on the company’s future performance, and that this will dilute you back to square one, it’s something you should account for.

Consider this seriously when deciding whether or not to invest. Also, look out for options, convertible notes, and performance shares that vest or convert in the future.

6. Can you ignore unnecessary distractions?

It’s well known now that putting former Miss Universe Jennifer Hawkins on the cover of the Myer prospectus was great at getting investors in but did nothing for the overall performance of the business, whose share price is now around $1.15 after listing in 2009 at $3.90.

Investing is as much an art as it is a science, but by following these six tips, you can get ahead of most.

Like most things in life that are worth having, getting shares in good IPOs is often a challenge

The vast majority of well-publicized listings are typically reserved for an invite-only group of investors – most Australians haven’t been able to get a look in. That’s where new technologies like OnMarket come in.

While we all know that markets can go down, as well as up, and that past performance is no indication of future returns, the 2015 IPO returns numbers are food for thought.

I am not brave enough to suggest that investor portfolios should consist solely of IPOs, though I do think the numbers tell a story that’s difficult to ignore.

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This information is of a general nature only. Before acting on any information, you should consider the appropriateness of it having regard to your particular objectives, financial situation and needs and seek advice. No information set out above constitutes advice, an advertisement, an invitation, an offer or a solicitation, to buy or sell any financial product or security or an offer of a financial service. Past returns and are not indicative of future returns.

What do you think is important to consider when investing in IPOs? Join the conversation below.