A Recipe for an IPO
4 Dec, 2020
 |
READ TIME 5 mins
Max Pacella
Investment Analyst

Could we have kippers for breakfast,
Mummy dear, mummy dear,
They got to have ‘em in Texas,
‘Cause everyone’s a millionaire”

Supertramp, “Breakfast in America”

Not chasing hot picks and waiting to ‘buy the dip’ is generally the sage advice that an experienced stock-picker will share with you.

There is, however, one volatile and explosive exception to this rule: Initial Public Offerings, or ‘IPOs’.

An IPO is the process of a private company offering shares to the public for the first time, generally at a price-premium for the pre-existing private shareholders, but hopefully at a discount to the potential or current value of the corporation.

The main objectives of going public are regarding raising capital and liquidity;

  • An initial injection of funds comes in from the sale of a certain portion of the company to the market
  • The buying/selling of shares becomes far easier for existing shareholders
  • The company itself may have easier and cheaper access to capital through the public market
  • Potentially capitalize on price momentum created by growing public opinions of the company (be it based on earnings, innovation, hype etc.)

In fact, we could not be discussing this topic at a more relevant time.

After a slow Q1 and Q2 during COVID, global IPO activity hit historic highs over Q3, with 445 IPOs globally raising a total of $95.0bn.

Source: EY

Amongst such a staggering volume of offers, how do you pick the winners?

Well, much like with stocks, nobody can see the future – and if they could we probably wouldn’t believe them.

But there are some clues and key ingredients involved in successful IPOs of the past.

So, let’s put together a recipe for a successful IPO, using ingredients and tools every investor has around their kitchen.

Ingredients

To make a successful IPO, we’ll need:

+ 2 cups of revenue growth & track record
+ 1 ¼ cups of a growing market segment
+ ½ teaspoon of a compelling company narrative
+ ½ cup of first-day price momentum

Sprinkle this with a strong management team – and serve in a wide moat of competitive advantage.

Depending on how this recipe pans out, research suggests that you cook between 1 week and 5 years.

Method

Firstly, no matter which industry or sector your IPO plays in, a key driver of an IPO’s success is the financial merits it boasts upon listing. This step is mostly common-sense, but it assists the credibility of any investment if it has a track record or a clear path to profitability.

There are exceptions – DoorDash and Airbnb have both doubled their valuations since April for their upcoming IPOs, without much financial improvement – but ‘key shareholders’ (professional investors who stay for the long term) traditionally want to see a compelling valuation upon listing.

Next we need to consider type of dish we want to make, the market which the listing company operates in. Below is a table that has been re-created from the New York Stock Exchange (NYSE):

SECTORPROCEEDS ($ USD)NUM DEALS% CHANGE FIRST DAY% CHANGE FIRST MONTH
Healthcare$24,992,160,2908535.3%74.9%
REIT$1,022,925,0003-2.2%-1.8%
Consumer Goods$6,661,590,601921.5%31.8%
Financials$21,576,770,4442311.3%22.0%
Industrials$2,649,731,1005-4.7%9.1%
Technology$20,099,595,4044126.4%34.1%

Source: NYSE, Q3 2020 IPO Results

No points for guessing that Healthcare and Technology were the star performers – the market has long identified these sectors as growing market segments, which stand to benefit over the medium-term even before COVID-19 hit.

This links back to the previous point; if the company is not profitable at the moment, being in a market that is growing at double digit % per year can certainly present a path to profitability.

The next factor is our ‘glaze’, i.e. what makes the deal shiny and succulent to potential investors: the company narrative.

This is a short and sweet step. Investors are far more willing to invest and throw momentum behind the IPO of a company if they can easily tell how it makes money.

4DMedical (4DX:ASX) listed in August on the ASX, with a clear story:

It is a medical imaging software maker, leading the way for medical institutions to replace old X-ray and CT scan equipment.

Most of us will have had a scan at a hospital, seen the enormous lumbering machines and imagined how expensive that equipment is.

The narrative of 4DX is being the best-placed company to replace all of that, on a per scan basis via 4D’s software, is an easy revenue model to comprehend. The stock is currently trading at a 243% premium to it’s first-day listing price.

Source: Bloomberg

The moment has now arrived – remove the IPO from the oven and set it down on the open market. This is possibly the most interesting factor to the success of the IPO – first-day price performance.

Nothing drives investing appetite and market attention like a stock moving 100% on it’s first day. According to research conducted by Forbes, IPOs that run at least 30% on their first day of trading strongly outperform the overall IPO market over a 5-year period.

It seems logical when you think about it, but if we break down the reasons of why these explosive IPOs outperform, it looks something like this: often, if a stock runs hard on the first day, it has been ‘undervalued’, so the price is starting from a low base and creates a huge momentum wave as investors pile in to a cheap opportunity. The market attention then may drive opportunistic capital towards a hitherto unknown company or listing, with sentiment being that if it opened strongly, then there must be excess demand and upside momentum – this becomes a self-fulfilling prophecy.

To mention one of Jesse’s favourite stocks, Beyond Meat (BYND:NYSE) jumped 170% on its first day of trading, a relatively unknown meat-alternatives company until that first market close. It then received near constant media coverage from major news networks to broker reports, momentum investors climbed aboard and long-term holders forecast blue sky for years – the stock rose 859% in under three months off that one day’s performance.

For an extra bit of flair to this dish, you’ll want to have a strong management team who are well equipped to handle the transition from a private to public company, and a competitive advantage which is known to value investors as a ‘wide moat’.

Both of these factors trend towards longer term success of the IPO.

According to PwC, CEOs and CFOs spend around 30% of their first year after listing purely devoted to investor relations, they mould their relationship with key shareholders and market opinion for the new public company.

If that new public company wants to stay at the top of their market, it needs to have some kind of market advantage that prevents a competitor coming along and taking their market share within a year – this is where a ‘moat’ comes in;

Apple (AAPL:NASDAQ) has brand loyalty, Microsoft (MSGT:NASDAQ) has an integrated network across its products, Alibaba (9988:HSK) has a monopolistic market share.

These are extremely difficult positions for any competitors to assail.

The takeaway

As with any equity investment, IPOs are behest to the whims of the market – and making the market happy is often as fiddly as getting a souffle to stay fluffy out of the oven. But in this metaphor, there are certain ways to whisk the eggs and firm up the mix, which will give you a greater chance of success.

IPOs are a uniquely dynamic and explosive investment opportunity; unless there is a significant market event or fundamental change in the company, no other listed equity would move the double & triple-digit percentages that a first-day IPO may.

There is a case to be made that you stand to gain the most from putting that extra bit of research and thought into an IPO than into an existing stock – but unless you plan to hold on for a few years, you may need to think first if the extreme moves are a little spicy for your portfolio’s palate.

The views expressed in this article are the views of the stated author as at the date published and are subject to change based on markets and other conditions. Past performance is not a reliable indicator of future performance. Mason Stevens is only providing general advice in providing this information. You should consider this information, along with all your other investments and strategies when assessing the appropriateness of the information to your individual circumstances. Mason Stevens and its associates and their respective directors and other staff each declare that they may hold interests in securities and/or earn fees or other benefits from transactions arising as a result of information contained in this article.

Related Posts