Post by oldman on Nov 4, 2013 20:02:04 GMT 7
Your First Million, 2nd Edition
Chapter 3 - Tools of the trade
IPO stocks are unique because the initial float available is usually finite. This is because the major shareholders usually cannot sell their stocks since they are under moratorium for 6 months or more. During that period, the available float is limited to what was released at the IPO. Usually, this is around 25% of the total number of shares., which means that it does not take much to ‘assert influence’ over an IPO stock. Hence, stagging small IPO stocks is an established strategy for traders.
In a bull market, an IPO stock is likely to do very well. But remember that the supply of stocks can drastically increase once the moratorium period is over. It is not uncommon to find new IPO stocks scaling new heights, only to fall back to the ground within 6 months’ time. For me, I am extra cautious when I look at new IPO stocks. After all, these are new companies to the investing public, and unless their value proposition is a lot better than existing companies, I tend to prefer investing in existing companies with good track records as public-listed companies.
The only IPO companies that will attract me are those that I am confident are going to the market because they are raising capital to fund an aggressive business expansion. This may sound like a motherhood statement but reality is that not many IPO companies will fall into this category.
There are many ways to dress up an IPO. Some will do corporate restructuring exercises to make even a loss-making company look profitable. Some even convert debt into assets, while others transform expenses into assets. Some profits are blown up in the year of the IPO. Others report multiples of their profits in the years before IPO, only to succumb to mediocre profits again in the years after the listing.
Companies do all these financial acrobatics because the market values companies based on historical or forward PEs (price-earnings ratios). Hence, it is in the interest of companies to present as best a PE as possible. In a way, it is how the market values IPO companies that results in all these financial acrobatics. Before one invests one’s hard-earned money in an IPO company, it is best that one goes through the entire prospectus with a fine-tooth comb to look out for all these financial juggling.
If I want to invest in an IPO company, the key element I look for is growth after the IPO. After all, when we invest in a company, we are really investing in its future and not its past.
However, I won’t even try to use this as my first yardstick when I look at IPO companies. This is because IPO prospectuses are written in such a manner that every IPO company has a glowing growth story, whether real or apparent. Suffice it is to say that listing is usually a marketing exercise to maximise the company valuation. The owners want as high a price as they can get for their shares and one cannot fault them as you would have done the same if you were the owners. The listing manager has also to market his services as he is likely to be competing with other listing managers. The owners are smart enough to pick the listing manager who offers them the highest price. Hence, the owners are marketing to the listing managers and the listing managers are also marketing to the owners. As a result, the valuation of the IPO is more than likely to be on the high side.
From the company perspective, when one plans for an IPO, it is logical for one to try to put as much profits into the year that matters most for the listing. The reality of P&L statements is that there is quite a bit of flexibility that management has over the distribution of profits from one year to the next. Hence, IPO stocks are usually dressed at their best.
An IPO is not only an expensive exercise but the company will also incur additional costs in maintaining its listing status. I think in Singapore, these adds up to betweeen $500,000 and $750,000 every year. These costs include the costs of additional directors, more detailed accounting, investor relations services, annual reports, listing fees and management time. For large companies, these additional listing costs may not account for much but for smaller companies with profits of $2 million a year, these amounts are not small and they can eat into the overall profitability in the years ahead.
Fundamental investors like me love bargains and I am unlikely to find bargains in newly listed IPO companies. This is why I usually shy away from these initial public offerings, at least until the hype is over. If you still wish to invest in IPO stocks, you may want to go through the check list below:
1. Borrowings
Does the company have borrowings? If so, are IPO investors paying for company growth a few years before it went public? I am therefore especially mindful of IPO companies that use the IPO proceeds to pay off debt.
2. Vendor or new shares
I feel that IPO does provide liquidity to existing investors but an IPO is just the start of a journey. To have management bailing out at IPO by offering vendor shares raises concerns over whether the business is peaking.
3. Profits
Are this year’s profits a lot higher than last year’s? Profits don’t usually do trampoline jumps without falling back to earth. I am especially mindful of profits doubling in the current year when it has been flat for many years before. Profit is after all only a man-made figure. I believe more in cashflow than profits, as cashflow is harder to ‘manufacture’ than profits.
4. Moratorium
I always favour IPOs where existing shareholders are not taking the IPO as an opportunity to unload and where all existing shareholders are under moratorium. At least, one knows that the float is just limited to the new IPO shares.
5. Change in accounting policies
Instead of expensing development, companies initiate capitalisation on the year of the IPO. This way, they immediately book a ‘profit from capitalisation’ and are not hit by depreciation. But in the years following the IPO, they may have to account for this depreciation. In other words, they are booking as much profits in the year of listing as possible, at the expense of the following years.
6. Capital restructuring exercises
It is amazing how these exercises can convert a loss-making company into a profitable one. Sometimes, debt is restructured into shares and a company with negative equity can become NTA-positive after the exercise. IPO investors then see a company that looks financially sound, but little did they know that if the debt was not restructured, the company might not have existed for very much longer.
It is a sad fact that so many IPO companies bang their gongs when they get listed, only to announce poorer and poorer results after listing. Perhaps, one of the key issues that budding companies face is the minimum profit requirements for a listing. Companies then have to do all kinds of financial acrobatics to reach this target. Some may scale down their profits the year before and reserve all the ammo for the year that matters. Others may book profits earlier from the following year to fill the year of listing. Yet others may recognise extraordinary gains or adjust the books to look best for the relevant year.
Problem with dressing up is that it makes it harder for the IPO company to even maintain the same profitability in the year after the IPO. Moreover, being a listed company adds new operating expenses that an unlisted company will not need to spend on. Dressing up an IPO is a norm and so, investors have to be extra careful when investing in such companies. When we dress up, we always look better than we normally would appear. Likewise for IPO companies. Take away the foundation and powder and you may then see the company for what it is truly worth. However, it does take quite a bit of experience and effort to be able to dissect the financials and expose the true picture, as most IPO prospectuses look like telephone directories.
Listing a company is prestigious. However, there are costs involved that may not be so obvious. The good thing about these costs is that it need not affect the P&L (profit and loss) of the listing aspirant, as the amount of money that is raised is usually at a premium to the par value of the shares sold. These IPO proceeds then increase the amount in the premium account, which is then used to offset the cost of the IPO. As such, the P&L is normally not affected by the IPO exercise.
The cash for paying the IPO expenses usually come from the pre-IPO investors. These are investors who put in money before the formal IPO and this money is often used to fund the IPO exercise. Pre-IPO investors do take a risk. In the event the company does not list, they may have their money tied up in an unlisted company.
For the IPO company, listing makes sense, as it does not have to cough up cash to pay for the listing and its P&L will also not be affected by this entire listing exercise. However, one must not forget that there is also a cost in maintaining a listed status. For a small company, the cost is likely to be in the region of about $400,000 a year. Auditors, accountants and lawyers are likely to ask for more, as there is likely to be more work and additional risks involved.
On top of this, there are the compliance requirements of a listed company and the fees for independent directors, company secretariat, public relations consultants and investor relations services. This amount does not include the additional management time needed to address the compliance issues of running a listed company.
For an IPO company that makes $2 million a year, $400,000 of additional yearly expenses represent a 20% decline in its potential profitability the following year, assuming business remains steady. The yearly expenses for maintaining a listed status can therefore be impactful. If a company has not been as profitable in the years preceding the IPO, I will be even more cautious, as there are many ways to dress up profitability before an IPO.
Here is some food for thought on the differences between private and listed companies as some of these differences can explain why it is not difficult for an IPO company to show much higher profits in the year of listing:
1. Private companies like to show low profitability, whilst listed companies like to show maximum profitability. As a private company, one would rather pay as low a tax as possible. Hence, private companies have a tendency to show as low a profit as possible. On the other hand, listed companies are often valued based on multiples of profitability. Hence, listed companies would want to show high profits.
For instance, with a PE (price-earnings ratio) of 10, every $1 million of additional profits would mean that the company would be valued $10 million higher. With this difference in recognising profits, it is not difficult for private companies to show higher profitability in the year of the IPO.
2. Private companies can have long-term plans, whereas it is more difficult for listed companies to do so. Listed companies have to report their financials at least half yearly, if not quarterly. If there is a fall in profitability, the market is likely to punish their shares. As a result, the managers of a listed company have to pay close attention to the short-term deliverables of the company. As a private company, there is less demand on short-term objectives. The managers in a private company can adopt strategies that may not yield short-term benefits but may yield significant long-term gains.
3. Private companies can keep their margins and business strategies to themselves, whereas there is pressure to be as transparent as possible when one is a listed company. In general, when the margins are good for a business, it may be better to keep the company private and not let others know how lucrative the business is. I have seen many IPOs that proudly display their net profits, only to find more competitors appearing after they release their IPO prospectuses, resulting in the companies declaring significant declines in margins after IPO.
Chapter 3 - Tools of the trade
IPO stocks are unique because the initial float available is usually finite. This is because the major shareholders usually cannot sell their stocks since they are under moratorium for 6 months or more. During that period, the available float is limited to what was released at the IPO. Usually, this is around 25% of the total number of shares., which means that it does not take much to ‘assert influence’ over an IPO stock. Hence, stagging small IPO stocks is an established strategy for traders.
In a bull market, an IPO stock is likely to do very well. But remember that the supply of stocks can drastically increase once the moratorium period is over. It is not uncommon to find new IPO stocks scaling new heights, only to fall back to the ground within 6 months’ time. For me, I am extra cautious when I look at new IPO stocks. After all, these are new companies to the investing public, and unless their value proposition is a lot better than existing companies, I tend to prefer investing in existing companies with good track records as public-listed companies.
The only IPO companies that will attract me are those that I am confident are going to the market because they are raising capital to fund an aggressive business expansion. This may sound like a motherhood statement but reality is that not many IPO companies will fall into this category.
There are many ways to dress up an IPO. Some will do corporate restructuring exercises to make even a loss-making company look profitable. Some even convert debt into assets, while others transform expenses into assets. Some profits are blown up in the year of the IPO. Others report multiples of their profits in the years before IPO, only to succumb to mediocre profits again in the years after the listing.
Companies do all these financial acrobatics because the market values companies based on historical or forward PEs (price-earnings ratios). Hence, it is in the interest of companies to present as best a PE as possible. In a way, it is how the market values IPO companies that results in all these financial acrobatics. Before one invests one’s hard-earned money in an IPO company, it is best that one goes through the entire prospectus with a fine-tooth comb to look out for all these financial juggling.
If I want to invest in an IPO company, the key element I look for is growth after the IPO. After all, when we invest in a company, we are really investing in its future and not its past.
However, I won’t even try to use this as my first yardstick when I look at IPO companies. This is because IPO prospectuses are written in such a manner that every IPO company has a glowing growth story, whether real or apparent. Suffice it is to say that listing is usually a marketing exercise to maximise the company valuation. The owners want as high a price as they can get for their shares and one cannot fault them as you would have done the same if you were the owners. The listing manager has also to market his services as he is likely to be competing with other listing managers. The owners are smart enough to pick the listing manager who offers them the highest price. Hence, the owners are marketing to the listing managers and the listing managers are also marketing to the owners. As a result, the valuation of the IPO is more than likely to be on the high side.
From the company perspective, when one plans for an IPO, it is logical for one to try to put as much profits into the year that matters most for the listing. The reality of P&L statements is that there is quite a bit of flexibility that management has over the distribution of profits from one year to the next. Hence, IPO stocks are usually dressed at their best.
An IPO is not only an expensive exercise but the company will also incur additional costs in maintaining its listing status. I think in Singapore, these adds up to betweeen $500,000 and $750,000 every year. These costs include the costs of additional directors, more detailed accounting, investor relations services, annual reports, listing fees and management time. For large companies, these additional listing costs may not account for much but for smaller companies with profits of $2 million a year, these amounts are not small and they can eat into the overall profitability in the years ahead.
Fundamental investors like me love bargains and I am unlikely to find bargains in newly listed IPO companies. This is why I usually shy away from these initial public offerings, at least until the hype is over. If you still wish to invest in IPO stocks, you may want to go through the check list below:
1. Borrowings
Does the company have borrowings? If so, are IPO investors paying for company growth a few years before it went public? I am therefore especially mindful of IPO companies that use the IPO proceeds to pay off debt.
2. Vendor or new shares
I feel that IPO does provide liquidity to existing investors but an IPO is just the start of a journey. To have management bailing out at IPO by offering vendor shares raises concerns over whether the business is peaking.
3. Profits
Are this year’s profits a lot higher than last year’s? Profits don’t usually do trampoline jumps without falling back to earth. I am especially mindful of profits doubling in the current year when it has been flat for many years before. Profit is after all only a man-made figure. I believe more in cashflow than profits, as cashflow is harder to ‘manufacture’ than profits.
4. Moratorium
I always favour IPOs where existing shareholders are not taking the IPO as an opportunity to unload and where all existing shareholders are under moratorium. At least, one knows that the float is just limited to the new IPO shares.
5. Change in accounting policies
Instead of expensing development, companies initiate capitalisation on the year of the IPO. This way, they immediately book a ‘profit from capitalisation’ and are not hit by depreciation. But in the years following the IPO, they may have to account for this depreciation. In other words, they are booking as much profits in the year of listing as possible, at the expense of the following years.
6. Capital restructuring exercises
It is amazing how these exercises can convert a loss-making company into a profitable one. Sometimes, debt is restructured into shares and a company with negative equity can become NTA-positive after the exercise. IPO investors then see a company that looks financially sound, but little did they know that if the debt was not restructured, the company might not have existed for very much longer.
It is a sad fact that so many IPO companies bang their gongs when they get listed, only to announce poorer and poorer results after listing. Perhaps, one of the key issues that budding companies face is the minimum profit requirements for a listing. Companies then have to do all kinds of financial acrobatics to reach this target. Some may scale down their profits the year before and reserve all the ammo for the year that matters. Others may book profits earlier from the following year to fill the year of listing. Yet others may recognise extraordinary gains or adjust the books to look best for the relevant year.
Problem with dressing up is that it makes it harder for the IPO company to even maintain the same profitability in the year after the IPO. Moreover, being a listed company adds new operating expenses that an unlisted company will not need to spend on. Dressing up an IPO is a norm and so, investors have to be extra careful when investing in such companies. When we dress up, we always look better than we normally would appear. Likewise for IPO companies. Take away the foundation and powder and you may then see the company for what it is truly worth. However, it does take quite a bit of experience and effort to be able to dissect the financials and expose the true picture, as most IPO prospectuses look like telephone directories.
Listing a company is prestigious. However, there are costs involved that may not be so obvious. The good thing about these costs is that it need not affect the P&L (profit and loss) of the listing aspirant, as the amount of money that is raised is usually at a premium to the par value of the shares sold. These IPO proceeds then increase the amount in the premium account, which is then used to offset the cost of the IPO. As such, the P&L is normally not affected by the IPO exercise.
The cash for paying the IPO expenses usually come from the pre-IPO investors. These are investors who put in money before the formal IPO and this money is often used to fund the IPO exercise. Pre-IPO investors do take a risk. In the event the company does not list, they may have their money tied up in an unlisted company.
For the IPO company, listing makes sense, as it does not have to cough up cash to pay for the listing and its P&L will also not be affected by this entire listing exercise. However, one must not forget that there is also a cost in maintaining a listed status. For a small company, the cost is likely to be in the region of about $400,000 a year. Auditors, accountants and lawyers are likely to ask for more, as there is likely to be more work and additional risks involved.
On top of this, there are the compliance requirements of a listed company and the fees for independent directors, company secretariat, public relations consultants and investor relations services. This amount does not include the additional management time needed to address the compliance issues of running a listed company.
For an IPO company that makes $2 million a year, $400,000 of additional yearly expenses represent a 20% decline in its potential profitability the following year, assuming business remains steady. The yearly expenses for maintaining a listed status can therefore be impactful. If a company has not been as profitable in the years preceding the IPO, I will be even more cautious, as there are many ways to dress up profitability before an IPO.
Here is some food for thought on the differences between private and listed companies as some of these differences can explain why it is not difficult for an IPO company to show much higher profits in the year of listing:
1. Private companies like to show low profitability, whilst listed companies like to show maximum profitability. As a private company, one would rather pay as low a tax as possible. Hence, private companies have a tendency to show as low a profit as possible. On the other hand, listed companies are often valued based on multiples of profitability. Hence, listed companies would want to show high profits.
For instance, with a PE (price-earnings ratio) of 10, every $1 million of additional profits would mean that the company would be valued $10 million higher. With this difference in recognising profits, it is not difficult for private companies to show higher profitability in the year of the IPO.
2. Private companies can have long-term plans, whereas it is more difficult for listed companies to do so. Listed companies have to report their financials at least half yearly, if not quarterly. If there is a fall in profitability, the market is likely to punish their shares. As a result, the managers of a listed company have to pay close attention to the short-term deliverables of the company. As a private company, there is less demand on short-term objectives. The managers in a private company can adopt strategies that may not yield short-term benefits but may yield significant long-term gains.
3. Private companies can keep their margins and business strategies to themselves, whereas there is pressure to be as transparent as possible when one is a listed company. In general, when the margins are good for a business, it may be better to keep the company private and not let others know how lucrative the business is. I have seen many IPOs that proudly display their net profits, only to find more competitors appearing after they release their IPO prospectuses, resulting in the companies declaring significant declines in margins after IPO.
