Everyone knows someone who has made a motza “stagging” an IPO. Babcock and Brown listed at a 65 per cent premium in 2004 and Platinum Asset Management at 72 per cent in 2007. Are the vendors giving away the company, or has irrational exuberance prevailed? Are IPOs a guaranteed way to make money or is the more common scenario far more subdued?

2009 began with desperation and despair. Markets were plumbing lows 50 per cent beneath their highs. Investors were running scared and desperately trying to manage margin calls. Many companies also found themselves over geared and a wave of equity capital raisings through placements and rights issues began. As the market rebounded more and more companies took advantage of the opportunity to raise equity, primarily through rights issues.

Now the next phase of the bull market has begun – IPO season.

When contemplating participation in an IPO an investor can take a long-term or short-term perspective. If considering the stock as a long-term portfolio holding, the business needs to be analysed in terms of the financial fundamentals, growth prospects and strength of management. A view on the intrinsic value can then be formed and the investor would only subscribe to the IPO if the offer price was less than this intrinsic value.

An investor (or trader) with a short-term perspective is hoping to make a profit by selling the stock soon after it lists, known as a stag profit. To quote Benjamin Graham, “in the short run the stock market is a voting machine, but in the long run it is a weighing machine.” In this case it is the voting machine that counts. The short-term investor wants to know if demand will exceed supply in the short-term and therefore bid up the price. The long-term prospects are less important.

To analyse demand the first step is to try and gauge how institutional investors are likely to react. Will the institutions be compelled or even required to acquire a substantial holding? IPOs most likely to be in demand are those for large market capitalisation stocks and especially with a large free float, i.e. most of the shares are available to trade on the public market rather than tied up with one or two investors. These characteristics mean that the stock will be included in the major indices. This in turn means that equity index funds will be compelled to buy the stock and active equity funds that are benchmarked against the index will also feel a strong compulsion.

For the retail investor, the ideal situation is where there is strong institutional demand but limited institutional supply. Some vendors will favour allocating stock to retail investors leaving the institutions short of their desired allocation and needing to buy the stock on market after it has listed. This may well be the case with the Myer float where management wish to look after their loyal customers, and was also the case with Platinum Asset Management.

For those hoping to make a short-term gain, the best floats are those were demand is strong, supply is limited, but somehow you manage to get some. Such opportunities do not come along often.

Most of an investor’s energy should go into analysing the fundamentals of the business to assess its value. Remember, the vendors are usually smart operators and they are not likely to give the company away. Whilst IPOs can be a lucrative hunting ground on occasions, there are also many traps for the unwary.

Chris Batchelor is senior technical writer for Kaplan Professional.

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