IPOs may be sexy but are they profitable?

Until recently many sharemarket investors regarded new issues - also called initial public offerings - as something of a free lunch.

You took stock from your friendly broker, waited until the company listed, flicked the shares at a good profit, then did it all again next month.

However, when Feltex forecast a plunge in profits it really spoiled the party.

The shares issued at $1.70 in June 2004.

At last count, when they were trading at 76 cents, some 9725 investors were staring at a $140 million loss.

Feltex aside, are new issues worth getting excited about?

Certainly they are probably the brightest star in many stockbroking offices as the traditional secondary market business from investors has slowed.

Investing in IPOs is fashionable, exciting, maybe even sexy, but is it profitable?

While IPOs are undoubtedly good news for the NZX and brokers it's not at all clear that a focus on new issues is a sensible move for mum and dad investors.

Indeed, just last year Warren Buffett, arguably the world's most successful investor, warned that you are unlikely to find too many bargains in the IPO markets.

"In an IPO the sellers decide when to come to market, so it's way less likely that it's going to come at a time that suits you," he said.

His partner, Charlie Munger, was a bit more blunt: "The average person buying IPOs is going to get creamed".

Stockbrokers around the world love quoting Buffett but for some reason his views on IPOs haven't got much publicity.

That's because new issue business is big business - with higher than usual margins and fat profits.

According to the Financial Times, the average cost for a company to do an IPO is around 6 per cent to 7 per cent of the market value of the stock.

In contrast, institutional broking rates get down to 0.5 per cent and below.

So while IPOs are good for the intermediaries, what historical research there is suggests that investors would do better as Buffett suggests by looking for bargains amongst stocks already listed.

One of the most exhaustive studies of IPO performance was published in the Journal of Finance a few years back.

It looked at about 5000 US IPOs between 1970 and 1990.

Investors who bought at the market price on the first day of trading and held the stock for five years achieved an annual return of 5 per cent.

Investors who invested in existing listed companies of the same size on the same day as the IPOs were purchased achieved a much higher five-year compound return of 12 per cent.

According to the authors, the lessons were clear.

If you can get an IPO at the offering price, it is often a great buy.

But do not hold on!

The subsequent performance almost always disappoints.

Good advice perhaps if you live in the US but even quickly selling out profitable new issues can be bad for your financial health in New Zealand.

That is because the tax department may decide that you bought the IPOs with a view to selling them which, with a bit too much short-term dealing in shares generally, could get you classed as a trader and your whole portfolio might be subject to capital gains tax.

For what it's worth, data on recent New Zealand IPOs confirms the US research.

Of the 55 companies that floated between January 2000 and March 31 of this year, 69 per cent have performed worse than the broader market since listing with five going bust.

The average unweighted annual return for IPOs in the 2000-2005 period was 3 per cent compared with the broad market which returned 8.9 per cent.

The New Zealand data shows however that if you were able somehow to invest only in the best IPOs you would beat the market by a big margin - for example Turners Auctions and Freightways are up by 150 per cent and 86.25 per cent respectively.

While the statistics for New Zealand IPOs versus the broader market are unflattering if they were adjusted for the issues you could easily participate in (Feltex comes to mind) versus those which were hard to get the numbers would look much worse.

Unfortunately picking the best primary issues is no easier than picking stocks in the secondary market.

A good rule of thumb might be: do not invest in any IPOs which you can get shares in.

And do not look to brokers for advice - nothing polarises investment opinions as much as an IPO.

On one side the advisers floating the company tour the country like evangelists promoting its attractions with a religious fervour, while on the other side those brokers who missed out on an allocation are usually bitter and will have at least a dozen reasons why you shouldn't touch it with a barge pole.

It's worth considering just why an IPO focused strategy is likely to underperform.

The first reason is Buffet's timing issue: the vendors are likely to be experts in the industry sector and will likely have a better feel for the outlook for their IPO than most mums and dads.

For example, Feltex and Mike Pero were floated after a very buoyant period for housing demand.

Second, the IPO market is a dedicated follower of fashion - remember how many technology IPOs there were in 1998/99 and how many of them have gone bust.

Following fashion in the financial markets is usually a recipe for disaster.

Third, the academics reckon the reason IPOs underperform over time is that they are often companies where the share price is pitched at a high multiple to the book value of their assets.

Value investors such as Buffet try to buy businesses below their intrinsic worth, so applying the opposite of that strategy - buying stocks with a high price and low book value - does not sound like too bright a strategy.

Mike Pero was floated at many times the book value of its tangible assets with much of its valuation comprising the worth of its brand.

So much for return - IPOs may not be great for your risk profile either.

Some people cite IPOs as being the lifeblood of a stock exchange but common sense and portfolio theory suggest that many new issues should be subscribed to by institutions and not mum and dad with $10,000 to invest.

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

A strategy focusing on IPOs usually means that the shareholder does not enjoy the benefits of diversification in terms of the lower volatility of a more balanced portfolio.

Research suggests the minimum number of different shares you need to own to do this is 50, meaning that mum and dad investors with limited resources and without access to specialist advice should more sensibly own managed funds with low fees such as the TeNZ and Midcap Funds.

* Brent Sheather is a Whakatane-based financial consultant.