Investors should be picky about flotations

Initial public offerings, more commonly known as IPOs, involve the sale of stock by a company to the public. Historically the preserve of smaller companies looking to raise additional capital to expand, IPOs have become increasingly attractive for large (often privately owned) companies looking to launch on the stockmarket or simply to sell some additional shares.

Many people became first-time investors in response to the privatisation share offers of the Eighties and reaped the rewards of a buoyant stockmarket and a fair price. More recently, the Royal Mail privatisation saw thousands of investors start their investment portfolios with a bumper return, albeit on only £750 worth of stock. However, with the IPO market now at full pace, and with the Alibaba IPO - reported to be the world's largest ever listing - just around the corner, there are some key questions that investors need to ask themselves before they participate.

When it comes to privately owned companies, the main question to ask is whether the owners will maintain a stake in their business?"

The first consideration is who the seller is. This may seem obvious but many investors fail to appreciate that this key variable is one of the most important factors and can make a significant difference to any investment return. Government flotations are typically priced attractively as there is definitely a desire to create goodwill for future voters, which makes these privatisations a good option.

When it comes to privately owned companies, the main question to ask is whether the owners will maintain a stake in their business? As an investor, you want to make sure that your interests are aligned with the owners of the business, so taking note of what the current directors and owners will do with their share of the business is a key indicator.

Cycle stage

The second most important factor is what stage of the cycle you're in. Stockmarket flotations typically only take place when equity markets are rising and sentiment is positive. Buying into the first few IPOs at the start of an economic upturn is likely to generate the best returns.

Once markets have been rising for a while, the sheer volume of IPOs increases dramatically - however, opinion is divided on whether multiple IPOs are a sign of strong market conditions or an indication that we might be reaching the end of a bull run (and there is a concerted effort by insiders to get new offers away at inflated valuations).

Price is next on the list and this one can be the most difficult element to gauge. Pricing companies fairly, in particular when there is no earnings history, is especially relevant when talking about "industries of the future". The dot-com boom highlighted how difficult it was to pick out star performers from the rest and because it was a new industry with multiple share offers it became even more difficult.

In theory, while each individual company looked potentially strong on its own, they were being priced in isolation rather than in the context of a wider, competing market. The results, or lack of them in many cases, are well known.

Difficult to value

We're certainly not in the same situation now but new technology companies remain the most difficult to value. Where a company has not made any profits, there is a tendency for the sellers to use highly positive, forward-looking assumptions about future growth and profits. Unfortunately, if these targets are not met, then this weighs heavily on the share price.

Some companies are adept at picking the best time to list. Candy Crush maker, King, came to market earlier in the year, fresh on the back of Candy Crush Saga being the most popular global app of 2013. However, the fickle world of gaming has seen their popularity falter and left their investors with a sizeable paper loss.

Even if companies do initially fall after their listing, that doesn't necessarily signal the end. Facebook launched in a blaze of glory, only to fall flat and then recover strongly again, perhaps revealing that even the largest companies need to come to terms with dealing with the responsibilities of shareholders and demonstrating that some management teams take a while to step up to that role.

In the main, share offers provide a short-term benefit to investors, with the share price typically rising to provide immediate gains. But by paying attention to the details, investors can hopefully avoid the bear traps and be selective so that they maximise their chances of success.

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.