Five red flags to watch out for in share market floats

The number of companies wanting to list on the share market are coming through thick and fast at the moment but how do you know if they're going to be a good deal or a dud?

The Herald talked to three different types of investors about what to look out for.

Motivation - why is the owner selling the business?
Companies who float on the share market typically do so to raise money to either grow or pay off debt.

An initial public offer (IPO) can allow the owners to exit the business either all at once or over time.


Grant Williamson, an adviser at broker Hamilton Hindin Greene says it's important to look at how much of the money being raised is going into the seller's pocket versus how much will be used to grow the business or pay down debt.

John Hawkins, chairman of the New Zealand Shareholders' Association, says owners who exit the business and pocket all the proceeds from the float often leave a business with a stressed balance sheet.

"Investors need to be aware of private groups of shareholders who are realising the reserves without leaving the company sufficient resources.

"They need to follow the money trail to see who is getting what out of the float, and what they are leaving for the retail investor."

Hawkins says a complete exit of the business can also show a lack of confidence in the long term prospects of it.

Rickey Ward, fund manager and head of New Zealand equities at JB Were, says he likes to see sellers keep at least a 20 per cent stake - anything less and it makes it easy to sell the remaining shares without other shareholders being aware of it happening.

Ward says finding out the true motivation for selling usually involves talking to the management.

"If the management don't make themselves available to talk to the public you've got to ask why?"

Ward says investors should also ask what the money raised will specifically be used for.

Using the money raised to grow the business is preferable to paying off debt, he says, otherwise you may just be helping the seller get the business in better shape to sell their remaining stake at a better price.

Value - is the business worth the price being asked for it?
Hawkins says a good business may not necessarily be a good investment if the price is too high.

The risks involved in the business need to be factored into the price.

Hawkins says some of the key risks of buying into an IPO is that you may be buying in at the top of the company's business cycle.

The company may also face changes in its competitive environment or may lose its edge to technological innovation.

"Unless the IPO is priced right and the company performs above their projections you can often find the share price getting hit especially if the market slows down soon after."

Williamson says there has to be something in it for those who buy shares through the initial public offer.

But it can be difficult for the average retail investor to assess this.

Williamson says that is where professional investors such as fund managers, brokers and other institutions can come in.

If the offer is priced too high based on the assessment by institutional investors it may not go ahead - that is what happened in the case of the recent Hirepool float.

Institutions take part in an auction style process called a book build which will help set the price based on a range.

If the value is seen as low the price will be set at the low end or below the bottom of the range.

Promises - can the business live up to its forecasts?
Williamson says potential investors need to have a look at the historic performance of the business and what is being forecast.

"If they do see a huge leap in the earnings they need to look deeper at this and ask why."

Investors need to assess if the forecasts are realistic based on the potential risks to the business.

People - who's in charge?
Williamson says the quality of the management plays a key part in deciding whether to invest.

"Check out what the experience of the board and management is."

Do they have a successful background or a skeleton in the closet?

If they have run a failed business in the past what is the reason the business failed?

"Reputation is a pretty big thing," Williamson says.

Hawkins says investors are primarily relying in those people's skills, judgement abilities and competence to ensure the company is a success.

"The success or failure of an IPO largely rests with them. If investors don't know enough about them or if their track record is suspect, the risk increases."

Fortunately, says Ward, technology has made it a lot easier to do this research.

"It's easy to do a quick Google search. Are they on linked in? Who are their friends."

Ward says it may not matter who is on the board but their skills should be complementary.

Proper analysis or gut instinct?
Hawkins says one of the biggest mistakes people can make when it comes to buying shares in an initial public offer is buying on emotion rather than analysis.

Potential investors need to do proper research and consider whether the company's forecasts are realistic, he says.

It's also a big mistake to jump in hoping to make a quick profit over a short time frame or to buy a stake based solely on other high profile investors jumping in.

Williamson says initial public offers aren't for everyone and typically it is more experienced investors which consider buying shares in them.

"IPOs are certainly not for everyone."

The more cautious investor is more likely to want to see a track record of a company's performance on the share market before buying in.

Hawkins says investors need to compare the opportunity of an IPO with already listed companies and not choose the IPO simply because it is being promoted by a broker, or reputable seller like the government.

"Investors need to apply the same criteria to an IPO as they do to any other new investment in their portfolio."