Adrift on a leaky float

By BRENT SHEATHER

Nothing polarises investment opinions as much, it seems, as a new issue - also known as a float or an initial public offering (IPO).

On one side the advisers floating the company promote its attractions with a religious fervour, while on the other side those brokers who missed out on an allocation usually have a dozen reasons why you shouldn't touch it with a bargepole.

In the US, websites, journals and advisers are focused solely on new issues. Locally, the investing public can usually be relied on to work themselves into a frenzy if they sense the opportunity to turn a quick profit.

If, as a stockbroker, you are unlucky enough to have an allocation of a popular new issue, your phone will ring hot at ungodly hours, with clients who you thought must have died or, worse still, lost all their money, suddenly resurfacing and greeting you as a long-lost friend.

But are new issues really worth all the effort? Are they the key to beating the market and living happily ever after?

The local evidence is unclear. Certainly some new issues do incredibly well - Vending Technologies floated in November 2000 at $1 and is, two years later, up 80 per cent.

At the other end of the spectrum, subscribers to Cabletalk's November 2000 issue, at 50c a share, have seen 60 per cent of their investment disappear.

Companies that float tend to be capital-hungry and the initial offering is inevitably followed by a cash issue within a year or two, which can pressure the stock price.

Brokers handling the issue are often caught between a rock and a hard place; the company doing the IPO employs the broker to distribute its shares to clients, but in most cases this means recommending a stock that, from a diversification point of view, has no relevance whatsoever to a small investor.

New Zealand has few IPOs (20 in 2000, three last year and five so far in 2002), so one cannot draw much in the way of useful conclusions about whether concentrating on them is a winning strategy.

However, one would expect that the owners of the business being floated are usually selling some or all of their equity because they believe the timing of the sale is attractive. Their sense of value is likely to be much better than that of the buyers.

As we have seen in the recent US internet boom-and-bust cycle, if you combine a rising stockmarket and the latest investment fashion with capital-raising entrepreneurs you get an explosive mixture.

In New Zealand, add a lax regulatory regime, and the potential for misallocating capital on a large scale seems high.

Thankfully, those factors have not come together locally since around 1986. That was a vintage IPO year where we saw all manner of strange business served up to a public hungry for easy profits (including possum farms and flower growing).

But if the local picture is unclear, longer-term US data is unequivocal: numerous studies show that IPOs tend to underperform the market, and the smaller the company the greater the degree of underperformance.

Academics often argue that the underperformance is not because these are IPOs, it is because they are typically small companies floated at a high price relative to their book value.

The other important point to note is that IPOs are a way of profiting from market sentiment - when the market is booming you get lots of IPOs, at precisely the wrong time to buy.

Worse still, the IPO market is a dedicated follower of fashion and, as tech investors know, blindly following the latest fashion is almost guaranteed to lose you money.

For what it's worth, data on recent New Zealand IPOs confirms the US research. Of the 26 companies that floated on the NZSE between January 2000 and October 21 this year, 73 per cent have performed worse than the NZSE40 index since listing, with 8 per cent going bust completely.

The average return for IPOs in 2000-2002 was -18.4 per cent, compared with the NZSE40 index, which was pretty much unchanged.

Five of those new companies announced hefty cash issues after listing. Of those five, three have fallen by more than 50 per cent since listing.

While that all sounds bad, if you picked a winning IPO you did very well. The average gain on the IPOs that have achieved a positive return since listing was 87 per cent.

The myth that IPOs are a sure road to riches probably has its roots in the tendency for the initial offer price to be pitched at a low level, causing a large jump in price on the opening day of trading. Of the 2866 US companies that went public between 1990 and 1996, the average return on the first day of trading was 14 per cent.

But statistics are one thing, real life is a different kettle of fish.

The catch is that, most of the time, unless we are executives of large corporates with lots of investment banking business (like Bernie Ebbers of Worldcom), or big institutional investors, we can't get much of the good floats but everyone is offering us shares in the losers.

Earlier this year the US Securities and Exchange Commission (SEC) launched a wide-ranging inquiry into how shares in IPOs were allocated and whether fraudulent agreements existed that led to artificial manipulation of stock prices after the float in return for higher fees for the investment banks behind the float.

I wonder if that happens in New Zealand?

So much for return, what about risk? Many people cite IPOs as being the lifeblood of a stock exchange, but common sense and portfolio theory suggests that most new issues should be subscribed to by institutions, not individuals.

Brokers in this country regularly see clients with portfolios dominated by past new issues, which have been constructed on the basis of each stock's possible gain on listing rather than with any regard to diversity.

Such a strategy is a recipe for disaster, not least because the promoters of issues usually have a better feel for timing the market than the retail investor.

To make matters worse, individuals do not always follow the plan and take the immediate gains, but rather tend to believe the positive press circulating immediately after a float and retain an undiversified portfolio.

Even the best-performing issues present investors with something of a dilemma: do you take the profit straight away and risk incurring capital gains tax on your entire portfolio or do you hang in there with an undiversified, and risky, portfolio?

It is intriguing that some advisers continually promote small, specialised IPOs to retail investors when portfolio theory - not to mention common sense - suggests they should go directly to a managed fund.

Why should Mr and Mrs Battler, with, say, $200,000 in equities, invest $10,000 in IPO Inc and so overweight that sector of that market?

And even if that could be justified, why pick IPO Inc when globally there might be 200 or so stocks in the same sector that could fit the bill just as well and which usually have a longer track record?

Sooner or later a New Zealand IPO is going to go badly wrong and the question of whether it was prudent for the Battlers to buy it will be tested by the courts.

So if IPOs on average underperform, are more risky and can mean tax problems, what is the attraction?

Behavioural finance theorists say many investors limit their purchases to stocks that grab their attention, and there are a good many reasons why stockbrokers, financial planners and investment bankers bring IPOs to their clients' attention.

However, those financial institutions with an investment banking and a retail advisory division can find themselves facing a conflict of interest.

The retail side can come under pressure to sell companies that the investment banking division is floating, even when it makes no sense for retail clients to buy into that investment.

Of course this sort of clinical approach ignores the tendency of some people to have a punt.

Unfortunately, for many people, the stockmarket presents itself more as a gambling venue than a medium for long-term, disciplined investment. The IPO market, as the main event, has attracted an audience that believes one merely has to buy a range of new issues to make extraordinary returns.

The simple fact is that focusing solely on IPOs is more like gambling than investing and while gambling may or may not be fun, most of us can't afford to lose.

* Brent Sheather is a Whakatane investment adviser