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7 tips on choosing the right IPO for your portfolio

Anthony Fensom  |  20 Jun 2017Text size  Decrease  Increase  |  

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Who is selling and who is managing the process are among key questions you need to ask when weighing up an Australian initial public offering.

 

Cobalt and medicinal cannabis are the hottest sectors for Australian initial public offerings (IPOs) in 2017, leaving the rest of the field in their wake. But with the majority of new listings sinking below their issue price, how can investors sort the wheat from the chaff?

As of 31 May, cobalt explorer Ardea Resources (ASX:ARL) led the IPO winners list this year with a 148 per cent gain, followed by medicinal cannabis company Auscann Group (ASX:AC8) with an 85 per cent rise and Singapore-based water treatment company De.Mem (ASX:DEM), up 80 per cent.

Two medicinal cannabis companies, CANN Group (ASX:CAN) and The Hydroponics Company (ASX:THC), enjoyed triple-digit gains on their first day of trading in May, perfect for “stag” investors seeking a quick profit. However, the gains faded later in the month as some of the sector’s momentum went up in smoke.

At the other end of the field, German potash miner Davenport Resources (ASX:DAV) has been the biggest loser to date with a 55 per cent drop on its 20 cent issue price, followed closely by Chinese farming company JiaJiafu Modern Agriculture (ASX:JJF) with a 53 per cent slide and Western Australian gold-copper miner Kalamazoo Resources (ASX:KZR), down 45 per cent.

Overall though, it has been a mixed year for IPO investors on the Australian Securities Exchange (ASX). Among 59 listings in 2017, including reverse takeover offers, 30 were trading below their issue price, six were flat and only 23 had moved higher, according to data compiled by IPO Society.

The uncertain environment has been reflected in the cancellation of numerous touted listings, including the planned $1.5 billion Officeworks float and the proposed $500 million IPO for appliances company Zip Industries.

As of 17 May, only US$660 million had been raised in new listings, compared to US$4.6 billion in 2016 and some US$15.2 billion in 2014.

Choosing the right IPO

The mixed market for IPOs means investors must look extra carefully before parting with their hard-earned cash, usually a minimum of $2,000. Among the key factors to consider are:

• Who’s selling: After the Dick Smith disaster, investors have put IPOs by private equity sellers under closer scrutiny, seeking them to retain a larger stake and hold onto it for longer than previously.


• Who’s in charge: The management team and board should have a good track record in the industry, and ideally with “skin in the game” that aligns their interests with other shareholders should the float succeed.

• What are the funds for: Watch out for IPOs where the bulk of the funds raised are paying out the original owners or repaying debts, rather than funding the new company’s growth. As Warren Buffett suggests, it is better not to buy something you do not understand.

• Is the company in the right sector: Last year’s hot sector may be this year’s coldest, like technology promoters found out when the dot-com bubble burst. Ideally the company should have sufficient growth prospects for the longer term and not just be a one-hit wonder or tapping into a fad.

• Is it a government privatisation: Investors in the 1990’s government floats of Commonwealth Bank (ASX:CBA) or Commonwealth Serum Laboratories (ASX:CSL) who held onto their investments would be smiling today. However not all government privatisations have fared so well, as seen in the second tranche of Telstra (ASX:TLS) shares floated.

• Pay attention to the risks: The prospectus should spell out all the risks, but do your own research too. Be careful of overly optimistic earnings projections or excessive fees to advisers and pay attention to any supplementary or replacement prospectuses that are issued.

• Are there better alternatives: Check out the competition as it may be possible to pay a cheaper price for a listed company in the same sector that is already profitable, rather than paying more for a riskier new business without an established history.

Brokers suggest a major new listing may change sentiment towards IPOs, with one such possibility a proposed $4 billion IPO by Perth-based Quadrant Energy. Others in the pipeline for 2017 include financial services group netwealth, which reportedly may seek more than $500 million, as well as Craveable Brands, which owns fast-food chains Oporto and Red Rooster, which is eyeing a $200 million IPO.

Yet not all floats are worthy of an economic moat rating, as seen with Morningstar’s pre-IPO report on poultry business Ingham’s. In a market where an estimated $8 billion of IPOs have been withdrawn, those that do succeed in 2017 will need to have more than their fair share of good fortune.

As Morningstar suggests, ultimately, buying shares of superior businesses and allowing them to compound over time is the surest way to create wealth in the stock market.

Long-term fundamentals such as cash flow, competition, economic cycles and stewardship are crucial since history has shown that “market sentiment is fleeting, momentum can quickly reverse, and the herd is sometimes a dangerous crowd”.

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Anthony Fensom is a Morningstar contributor. This is a financial news article to be used for non-commercial purposes and is not intended to provide financial advice of any kind. Opinions expressed herein are subject to change without notice and may differ or be contrary to the opinions or recommendations of Morningstar as a result of using different assumptions and criteria. The author does not have an interest in the securities disclosed in this report.

© 2017 Morningstar, Inc. All rights reserved. Neither Morningstar, its affiliates, nor the content providers guarantee the data or content contained herein to be accurate, complete or timely nor will they have any liability for its use or distribution. This information is to be used for personal, non-commercial purposes only. No reproduction is permitted without the prior written consent of Morningstar. Any general advice or 'class service' have been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), or its Authorised Representatives, and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. Please refer to our Financial Services Guide (FSG) for more information at www.morningstar.com.au/s/fsg.pdf. Our publications, ratings and products should be viewed as an additional investment resource, not as your sole source of information. Past performance does not necessarily indicate a financial product's future performance. To obtain advice tailored to your situation, contact a licensed financial adviser. Some material is copyright and published under licence from ASX Operations Pty Ltd ACN 004 523 782 ("ASXO"). The article is current as at date of publication.