WASHINGTON, March 21, 2013 – In today’s edition of “Morning Market Maven,” our daily stock market column, we explored at some length our decision to get in on Aviv REIT’s initial public offering (IPO). Aviv (AVIV), for those who haven’t read the column, is a somewhat different flavor of Real Estate Investment Trust that invests in specialized nursing care properties as opposed to your everyday variety of mortgage REIT. But more to the point, it’s also an IPO, a topic we decided to cover today in this column, which generally deals with topics a bit more in depth.
IPOs vs. Secondaries
Generally, there are two ways that new publicly traded stock comes into the market place. The first occurs when an already-traded public company such as Citicorp (C) decides to issue more shares. Such an issue is called a “secondary,” referring to the fact that the underlying stock is already publicly traded, so the additional shares are a “secondary” occurrence.
Secondaries may or may not be “dilutive” to existing shareholders, but you have to read the prospectus of the issuing company to figure that out. If the “new” shares (we’re using quotes to indicate they may actually exist internally) are truly new, or if they’re owned by investors but not factored into public financial reports, adding them to the existing shares, or public “float,” will have the effect of decreasing earnings per share and thus may cause the stock price to drop when the secondary goes public.
In other cases, the secondary is not dilutive because the shares in the offering have been counted on the balance sheet from the get-go and are simply being sold to the public by selling shareholders because these large shareholders want to realize (presumably) their profit on the stock and use the resulting funds to diversify their portfolios. Such shares are not dilutive since, to oversimplify a bit, they don’t change the earnings per share math.
The second way new publicly traded stock comes into the marketplace is via the initial public offering, or IPO—its familiar acronym. An IPO stock is generally a stock that’s never been publicly traded before. It could be a new, speculative startup company, or it could be a company that’s been in business for a considerable amount of time as a private entity but decides, in order to initiate faster growth or increase in size, that it must raise a substantial amount of capital beyond a reasonable loan. In any event, any company doing an IPO has decided to raise money by selling new shares to the investing public.
What’s a “re-IPO”?
We should note at this point that there’s a fairly common subset of the IPO here that, for lack of a better name, we’ll call a “re-IPO,” even though that’s not a term in formal use.
An easy-to-understand example of a re-IPO would be General Motors (GM). At the height of the 2007-2009 financial crisis, the original General Motors, for all intents and purposes, went bankrupt. The bankruptcy was unusual in that it was preplanned, worked out with the Federal government (unsatisfactorily for the taxpayer we might add), and exited rather quickly.
During GM’s so-called “pre-packaged bankruptcy,” current GM shareholders were wiped out as were (illegally, we think), many bondholders as well. The government then worked with GM to create entirely new shares and offer them to the public, thus recouping part of the Federal bailout money.
Since the old GM stock was dead, the new GM stock—even marketed under the same ticker symbol as the old—was essentially the brand new stock of a recapitalized manufacturing company. Hence, a “re-IPO,” or the issuance of brand new shares of a company that had already been publicly traded.
Other more common examples of re-IPOs include companies that, for various reasons, have been taken private by vulture venture capitalists, presumably restructured for greater profitability; then brought back public by these same investors as an IPO. A good recent example was the re-IPO of Dollar General (DG), issued roughly two or three years ago by the investors who’d taken it private.
Re-IPOs should raise the caution flag. The investors who take a public company private often strip out and sell the good parts, profiting in the process. In addition, they often help themselves to a sometimes-substantial portion of the re-IPO’s proceeds, calling it a “special dividend,” something you should be on the lookout for in the re-IPO’s prospectus.
We frown on this considerably on this practice, although it’s not uncommon alas, being another way the investors can mine considerable profits before letting go of the stock. Such greed—since that’s really what it is—often saddles the IPO with excess debt, which may hamper future profitability and thus the return for investors in the IPO as well.
That said, some of these re-IPOs, debt-laden though they may be, can often be popular with the public if the underlying business is regarded as attractive as in the recent re-IPO of Norwegian Cruise Lines Holdings (NCLH). We took a chance on that one, hoping for a couple of points and were pleasantly shocked when that recent issue jumped over 60% in its first month of trading.
And to circle back, that’s why the Prudent Man finds a certain portion of these admittedly speculative investments—IPOs in general—to be attractive as a side issue in nearly any portfolio that isn’t already exclusively dedicated to providing current retirement income.
To IPO or not to IPO
A certain portion of IPOs will always disappoint. The most notable recent example of this is the Facebook (FB) IPO debacle in which the company’s IPO price was pumped up beyond reason while shares issued were raised to absurd levels. This resulted in a sickening months-long swan dive for IPO investors who, if they kept holding the bag, lost half their money in the deal when the stock reached bottom.
True, the stock has recovered about half that at this point. But, frankly, if you’d kept your money in the bank and then invested in, say, Norwegian Cruise Lines instead, you’d already be sitting on a tidy profit well in excess of your original investment instead of still waiting—like Facebook IPO investors—to merely recover your original investment.
Another counter-example is the more mature Facebook competitor LinkedIn, whose employees are pictured above ringing the opening bell on the exchange the day of their IPO. With a burp here and there, LinkedIn (LNKD) has soared almost continuously since its offering, current priced at an astonishing $174 per share based on its ever-increasingly profitability.
FB and NCLH are the two extremes of the IPO coin-flip, however. Most IPOs and most secondaries fall somewhere in between. In our own experience, we make money on these issues about three out of four times, so for us at least, they’re worth taking a chance on.
Four rules for investing in IPOs
What do we look at when deciding on which IPOs to try and which IPOs to pass up? We’ll share that with you now. But first, a mild caveat.
Our accounts are with discount broker Charles Schwab. Discount brokers, as a rule, are not the brokerage houses underwriting most IPOs—full service brokerages like Merrill Lynch, Morgan Stanley (which is now fully absorbing its full service subsidiary Smith Barney from Citicorp), Goldman Sachs and the like. Smaller houses and discount houses form part of the “selling group.” They help market shares to their customers but generally aren’t on the financial hook for the offer. Thus, they’ll only get shares in the end if the underwriters actually give them the shares and also under certain restrictions.
Schwab’s restriction—although it’s not mandatory—is that its IPO investors hold the shares for at least 30 days prior to selling. There are a lot of technical reasons for this, which we won’t bother to get into, and it’s not capricious. But this subjects Schwab’s shareholders to the vagaries of the market for a trading month while full service brokerage customers can generally “flip” an IPO on the same day it’s issued if the initial stock “pop” is high enough to make them happy.
Often, after the first few days, but not always, the stock will gradually sink and lose a good deal of the initial pop. That’s happening to us in slow motion in an IPO we got into last week. That said, though, unless the whole issue really tanks in the first 30 days, you’re still generally left with a half-decent profit, which you otherwise might not have had, so one can’t complain overly much. That was certainly the case with NCLH which was considerably higher a month after its IPO than it was on the day of issue.
Now, back to what we look for in an IPO:
First, can you tell if this IPO is profitable? That’s not always easy, as even the prospectus may not tell the whole story. Furthermore, a great many IPOs DO NOT make a profit. Profitability in an IPO isn’t the whole story, but it’s a big green light for the Prudent Man if he can see current or upcoming black ink in the issue. Profitability, after all, can make an IPO less speculative.
Second, what’s being done with the proceeds. The Prudent Man absolutely hates it when most or all the proceeds are eaten up by “special dividends” for the vulture capitalists who are selling the shares. This isn’t illegal, of course. But it does mean IPO investors will be stuck holding the back to pay off the loans that created these “special dividends” in the first place, thus subsidizing the yachts and lifestyles of the rich and famous who unloaded these shares. That’s galling. On the other hand, you can still make good money on this stuff anyway, particularly if the IPO is in a hot or promising tech area. It’s a coin toss, but viscerally, we don’t like to see this.
Third, what’s the competition in the IPO’s business niche? If the IPO is a biotech that’s in a Stage III trial for approval of a one-injection TB cure, even if it’s bleeding capital, I’d likely give it a shot, since there is no on-injection TB cure, particularly for the alarming variety of antibiotic resistant TB that’s now showing up.
On the other hand, if the IPO has a “newer and better” competitor to the iPhone ready for production, I’d absolutely take a pass. Given the periodic near-death encounters of Blackberry (BBRY) and Apple’s (APPL’s) difficulties with supplier-competitor and alleged patent thief Samsung (various symbols), this hypothetical one-product company is a fresh bankruptcy waiting to happen. In other words, choose your IPO niche wisely.
Finally, there’s the matter of IPO pricing, and this has changed over the years. Typically, IPOs are offered to investors in a narrow trading band. For example, let’s say that XYZ Corp. is going public tomorrow and its current offer price is projected to fall within the 18-20 dollar range. $18 would, naturally, be considered the lower end of the trading band while $20 would be the higher end.
Pricing doesn’t really take place until the books are closed on accepting stock offers, typically the evening the offer is officially priced before opening the next day for official trading. That evening, officials from XYZ, the lead underwriters, other underwriters, and additional analysts, get their heads together to determine what the actual offering price will finally be.
What actually happens in an IPO is that the underwriters are actually on the hook for buying the entire issue. The “offering,” then, as such, is the price investors will get on the stock which will include the substantial fees the underwriters get for assuming the risk and performing all the due diligence and other nightmarish stuff that’s required to bring the offer through to its logical end.
The “offering price,” which includes all this, is what the public will actually pay if they can get any IPO shares. One inducement to getting in on the IPO for the public is the fact that the shares are, unusually, offered without commission. Of course, as we’ve just described, some commish is already built into the offering price. But if the stock really pops, no one will much care. The general public, many of whom foolishly chase IPOs upward after the offer, does, in fact, have to pay the commission, giving a further advantage to the IPO purchasers.
But interpreting pricing is a sticky wicket. The best offers are a bit of a devil’s bargain struck by the underwriters and tolerated by XYZ Corp. XYZ, of course, wants as much money as possible out of the deal for whatever purposes it intends to use that money. And that, of course, is what they pay the underwriters to determine. The underwriters want XYZ to be happy, too, so they try to get their clients as much money as they can.
On the other hand, they want investors to get that beloved pop as well so they’ll reliably come back for more IPO feeding frenzies in the future. If the underwriters can strike that happy balance, giving XYZ the maximum $$ possible while giving new investors the kind of nifty pop they can brag about at their next cocktail soirée, that’s indeed the Promised Land for all concerned.
For this reason, in most instances, the underwriters try to price the IPO slightly under what they think it will command in the open market the next day, an art, perhaps, more than a science, but a critical one nonetheless. Back in the 1980s, when the Prudent Man was a broker himself, if our mythical XYZ IPO—suggested to price, if you recall, in an 18-20 dollar band—were priced at $17, that was a great sign to get right in as the stock would likely pop.
Psychology has changed today, however. Now, more often than not, an IPO that prices below the lower end of the band is interpreted to be undersubscribed, i.e., unpopular, thus forcing a discount below what XYZ originally wanted in order to sell the shares.
Even worse: if XYZ prices below the band AND increases the number of shares for sale, effecting a further devaluation. Sometimes, this will actually cause a pop to happen. But these days the opposite if often true, so we usually take a pass when this happens.
The flip side? Counter-intuitively, if the stock prices, say at $21, or even $22 or $23, above the high end of its trading band, that means, likely, that it’s oversubscribed. In other words, there’s more demand for the issue than anticipated, meaning that investors and hedge funds will chase it higher when it opens, sometimes leading to a very substantial pop.
That, in fact, is what happened in Facebook. Except the tell here was when they kept creating shares at the much higher price, indicating pure greed rather than investor happiness was the goal. FB aside, however, pricing above the band these days, unlike in the 1980s, is interpreted as good news today, particularly in tech.
None of these rules work 100% of the time. But these rules are what have kept the Prudent Man relatively happy playing the IPO game since the market bottom in March 2009. Future results, of course, are never guaranteed, and perhaps some day, our algorithm above will shift back to the 1980s paradigm. But right now, that’s the way we play ‘em.
Friday’s IPO choices
Following on from our earlier Market Maven report where we discussed the AVIV IPO where we may or may not get shares, we’re also looking at IPOs of West Corporation—billed as a communications company—and Marin, which specializes in digital advertising management. Additionally, another, more traditional mortgage-style REIT, Five Oaks, is also on tap; and, to make things interesting, a secondary issue of Graphic Packaging Holding Co. (GPK) jumped into the queue last night.
As it stand right now, IPO-wise, we are most interested in West Corporation, which already has a good track record as a company, although it will come out of its IPO somewhat too highly-leveraged. GPK, maybe. It’s a secondary, which means its stock is already publicly traded, so it’s unlikely to pop and may even erode a bit.
We actually had good luck with a previous secondary in this stock last fall, and are tempted to try again. But this sale, as the last one, is coming from selling shareholders so the company won’t get any of the proceeds. It’s a little difficult to find out how far along the “selling shareholders” are in getting rid of their stock, so we’re not sure how much remaining overhang may effect this packaging company’s stock, so we need to do a little more research.
We’ll report on what luck we may or may not have had in tomorrow’s edition of Morning Market Maven, and follow up on Monday with news, if any, on the other IPOs.
As always, we emphasize here that ALL IPOs are risky for one simple reason: no track record to run on. We consider every one of them to be a speculation, and advise you to consider them such as well. Travel at your own risk here. Our commentary above is provided to give you some guidance on how to choose IPOs in the current very strange market. Things change, and this guidance may change as well.
IPOs are “risk-on” investments in the extreme. For that reason, it’s never advisable to risk money today on an IPO if you think you may need that money for something important tomorrow. Always be prudent.
Disclaimer: The author of this column maintains several active trading and investment portfolios and owns residential and investment real estate.
Any positions mentioned above describe this author’s own investment decisions and should not be construed as either buy or sell recommendations. The current market is highly treacherous and all investors travel at their own risk, so caution should be exercised at all times.
Illustrations, charts, commentary, and analysis are only the author’s view of current or historical market activity and don’t constitute a recommendation to buy or sell any security or contract. Views, indications, and analysis aren’t necessarily predictive of any future market or government action. Rather they indicate the author’s opinion as to a range of possibilities that may occur going forward.
References to other reporters, analysts, pundits, or commentators are illustrative only and do not necessarily represent an endorsement of such individuals’ points of view. If specific investment vehicles are mentioned in any article under this column heading, the author will always fully disclose any active or contemplated investments in said vehicles.
Read more of Terry’s news and reviews at Curtain Up! in the Entertain Us neighborhood of the Washington Times Communities. For Terry’s investing and political insights, visit his Communities columns, The Prudent Man and Morning Market Maven, in Business.
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