Brent Sheather: IPO's - More flop than pop

An IPO's 'pop' is frequently followed by a 'flop'. Photo / Thinkstock

The finance industry and the NZX in particular is, with the conclusion of the SOE sales, anxious to keep the IPO pipeline and thus the good times they imply, rolling. The banksters are therefore promoting the idea that IPO's (Initial Public Offerings like Genesis, Meridian etc) are something that should be constantly on the radar of retail investors.

Really? As with so many "good ideas" from the investment banking sector the reality is, more often than not, that what is good for the industry is anything but good for mum and dad.

It is easy to see why the finance sector likes IPO's. For a start they mean new assets to manage, trade and charge commission and spreads on and, in respect of commissions, IPO's attract much higher fees than transacting in the secondary markets.

The recent issue of Kiwibank junk bonds paid total commission of around 1.25 per cent to the organising brokers - not bad for a fixed interest product - and that infamous Feltex float inflicted total brokerage fees of around 4-5 per cent on investors.

The underlying selling proposition with IPO's, admittedly ridiculous but successful nonetheless, is that the share or bond which is the subject of the IPO is being sold below the price at which it will trade when it lists on the secondary market. Whilst this does happen every now and then, especially when the Government sells assets, in aggregate the proposition is silly for these reasons:

• Firstly the broker acts for the seller as well as the buyer but it is usually far more engaged with the seller as the seller has more money thus the broker is obliged to maximise the price for the seller at the expense of the buyer.

• Secondly the seller is normally far closer to the business than the buyer (think venture capitalist or management/owner liquidating their holding) thus has a better appreciation of the value of what they are selling.

• Thirdly while some IPO's "pop" on listing it is usually the seller that determines the timing of the sell-down so "pop" is frequently followed by "flop".

Consequently it's no surprise that the long term data on the post flotation performance of IPO's shows that they underperform. Whilst some IPOs are priced to deliver small immediate gains their long term performance after listing is poor according to numerous studies.

For example, writing in the Financial Times, Elroy Dimson and Paul Marsh at the London Business School found that, when looking at UK IPO's between 2000-2011 that returns over long periods were poor in both absolute and relative terms. After two years IPO shares had lost about a fifth of their value suggesting that IPO stocks tend to be overpriced at IPO.

The US experience is the same. Jay Ritter, Professor of Finance at Florida University and probably the world's foremost expert on IPO's was also quoted in the FT. He said "on average the long run performance of small company IPO's has been poor" and "the pattern of small company IPOs underperforming is true in Europe and the US".

That is the return dimension of IPO's explored. But there are two sides to investing and the other is risk. In respect of portfolio risk IPO's are generally very bad news. Thus the other big issue with IPO's is that IPO companies are generally small stocks therefore the addition of an IPO stock to a portfolio introduces higher risk and high tracking error into that portfolio.

This was very evident in a legal action against a stockbroking firm recently where I was an expert witness. The broker concerned managed the portfolio on a discretionary basis where he made the decisions for the client .... not always a great move.

Recall Oscar Wilde's comment that "a stockbroker is someone who invests your money until it is all gone". That is almost what happened here. The reality of "discretionary" in this case was that whenever the firm underwrote the new issue of a company which was unpopular with clients the discretionary client ended up taking lots of the surplus stock. Nice business model.

Because most stocks being IPO'ed are small they don't constitute a big part of a stock market index. Investment theory and investment practice says that the least risky portfolio is the portfolio that approximates the weightings of the index.

For example Fletcher Building is about 10 per cent of the NZ stockmarket so should be about 10 per cent of a portfolio. If a fund manager likes Fletcher Building he might go to 10 per cent plus 1 and if he doesn't like it he might go to 10 per cent minus 2. This is how fund managers manage risk but often anything goes as far as retail portfolios are concerned.

The fund manager strategy is acknowledged as best practice globally and is the rationale behind index funds which we know outperform most active fund managers. For sure there are things like the small company effect and other smart beta strategies but the market capitalisation weighted strategy is the most common and easiest to implement.

However that strategy doesn't sit well with a broker who is trying to sell you an IPO because for example on that sort of a strategy Feltex wouldn't have got much traction amongst retail investors.

In the court case I referred to, the poor client ended up with huge holdings in lots of stocks underwritten by the broking firm, all of which performed badly, and many of which went bust. So to be clear buying IPO's in anything but the biggest companies like Genesis, Mighty River and Meridian is not prudent unless of course you can pick the good ones from the bad ones and you can get access to them. Good luck fool.

The hard to get nature of attractively priced IPOs prompted one comedian in the FT to comment once "that he would never buy shares in any IPO he was able to buy shares in".

So if you combine the fact that IPO's are generally small stocks which make portfolios risky, that you only get access to the unattractive IPO's and that on average IPO's underperform the broad market after listing it is not difficult to conclude that they aren't the "no-brainer" the finance industry likes us to believe they are.

Unsurprisingly the world's best share investor, Warren Buffett, isn't into IPOs either and he has had a bit to say on the subject, none of it positive. He said "in an IPO the sellers decide when to come to market so it is way less likely that it is going to come at a time that suits you". Buffett's partner, Charlie Munger, said "the average person buying IPOs is going to get creamed".

Next week we will look at the Genesis float to see who got what and why, and then ask the question whether, in light of the FMA's prime objectives of encouraging fair and transparent markets, the IPO sales process in NZ meets these objectives. Hint: the answer is not yes.

Brent Sheather is an Authorised Financial Adviser. A disclosure statement is available upon request. Brent Sheather may have a financial interest in the companies mentioned in this article.