ASX floats: What to consider before buying into an IPO

A company’s decision to float on the Australian Securities Exchange (ASX) is typically done together with an initial public offering (IPO) which allows them to raise the funds needed to expand the business. That’s great for those responsible for bringing a company to market, but not always great for you, the poor old punter.

With that in mind, Azzet ran a rule over what you need to know before investing in ASX floats.

An IPO can provide a ground-floor opportunity to acquire tomorrow’s ASX leaders before future growth is factored into the price. 

But the opposite is also true, and based on the ASX’s recent past, you’ve got a 50-50 chance of an IPO being valued at less than what you paid in the first 12 months. 

First the history lesson: The ASX is littered with examples of floats that didn’t make shareholders' money, either short-term or even over the long haul. 

So how can you ensure you back the next  Guzman Y Gomez (ASX: GYG) - up from an issue price of $22 last June to $33.34 today - instead of future share market debris? 

Weeding out the duds
 

The trick to isolating quality IPOs from the duds, claims Bruce Apted senior portfolio manager at State Street Global Advisors is avoiding overpriced and over-spruiked companies wired to lacklustre sectors with questionable growth projections. 

When considering any IPO, Apted says the long term is a much better approach than trying to sell immediately after the IPO for a quick profit – aka ‘stagging’. 

The trouble with any company’s glossy (IPO) prospectus, adds Apted, is that it’s basically an advertising document, and that the brokerage/investment bank underwriting the IPO are salespeople. 

Equally important, he says investors need to remember that there are no philanthropic motives when companies decide to float their stock. 

“If the [IPO] prospectus doesn’t provide full transparency, you don’t have the information to assess the business and are unable to make an informed decision,” Apted warns.

While a lot of share market investors have become unaccustomed to looking at the numbers, Apted recommends going back to old-fashioned fundamentals. 

That means only looking at floats from companies with consistently above average return on equity (ROE), with little debt and not too much goodwill on the balance sheet. 

There's homework involved
 

However, given that these measures provide an incomplete picture, the better way to pressure-test any IPO, says Apted is to: 

1. Understanding the business model in the context of its competitive environment.
2. Examine the likelihood of the company generating consistent profits.
3. Investigate the potential future risks to the business. 
    

Is the underlying stock profitable?
 

Echoing similar concerns, Nathan Bell, portfolio manager at InvestSMART, recommends treating IPOs like any other ASX stock, and if there’s no clear path to profitability, don’t buy them. 

“If it’s private equity that’s selling, you’d do well to run a mile,” Bell told Azzet. 

“Usually they load the business up with debt, don’t spend enough on capital expenditure to show low depreciation and high historical earnings figures that aren’t sustainable.” 

He encourages you to ponder the immortal lines of Warren Buffett, the world’s most successful shareholder, when he quipped: 

“It’s almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less knowledgeable buyer”. 

If the insiders who know the business backwards are selling, Bell ponders, ask yourself why you’d buy from them? 

He recommends investigating previous financial statements of companies planning to float, to find out: 

1. If IPO forecasts for future revenue look realistic.
2. Whether the money raised is being earmarked to fund expansion or repay debt.
3. The amount to be paid to the existing owners. 
    

“Check insider-selling escrow periods and how many shares are in escrow,” urges Bell. 

“Often the amount is small compared with the initial sale through the IPO, and the escrow period also makes it look like the insiders are heavily invested when they’re not.”