It’s a season of monster IPOs.
In July, China’s fifth-largest smartphone manufacturer, Xiaomi Corporation (Exchange: Hong Kong; ticker: 1810), raised US$4.7 billion when it listed its shares on the Hong Kong Stock Exchange. It was the biggest initial public offering (IPO) of 2018… and Hong Kong’s biggest in four years.
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A few weeks later, China Tower (Exchange: Hong Kong; ticker 0788), a telecoms tower operator, raised US$6.9 billion in what was the world’s biggest listing in two years.
Both of these shares have bounced around, but right now are within a few percent of their issuance prices.
In coming months, Bitmain Technologies, the world’s biggest producer of cryptocurrency mining chips, might try to go public in a Hong Kong IPO that could raise as much as US$3 billion, according to press reports.
As the U.S. – and global – bull market in stock markets grows older, it’s not surprising that more companies are clamouring to go to market. No one wants (and few issuers are even able) to go to market in a down market. So for companies looking to raise capital, there’s no time like now.
That should be a warning sign to investors inclined to invest in today’s hot IPO.
Before you buy into an IPO…
If you’re looking at IPOs like these – or any other ones – it pays to get answers to these seven questions first. (How? Your broker should be able to answer these questions – or, far better, you should be able to see the publicly available documentation on the company to find out yourself.)
1. Who gets the money?
The whole point of an IPO is to raise money from investors. The thing is, who gets the cash?
Sometimes the founding shareholders (who are usually the management) of a company receive some, or even all, of the proceeds of a share offering. If so, the key question is this: Why are they selling? After all, these insiders know better than anyone the real prospects of the company. And if they’re selling, what does it say about the company’s prospects? Nothing good.
Of course, that’s not entirely fair. The founding shareholders of a company may be looking to take some money off the table, after investing years and funds into building the business. They may want to diversify their portfolio of assets – and maybe buy a yacht.
However, from the perspective of a future shareholder (that is, the buyer of shares in an IPO), it’s much more encouraging if the proceeds of an offering are to be invested in the further development and expansion of the company, than if current shareholders are cashing out. And in any case, the founding shareholders should be holding on to a significant stake in the company, so that they continue to have skin in the game.
In China Tower’s case, the company said that it planned to use 60 percent of the proceeds from the IPO on capital expenditure. That makes sense because China wants to fast track the upgrading of its mobile network infrastructure to accommodate speeds that are required for the Internet of Things (IoT) industry.
Another 30 percent of the IPO proceeds will go to repaying existing loans, and the remaining 10 percent go towards working capital. Meanwhile, the existing owners – including China’s top three telcos (China Mobile, China Unicom and China Telecom) – retained 75 percent of the expanded capital base.
2. Why now?
The worst answer here is “Because I can now – but I might not be able to later”… that is, when the bull market dies.
A company may be selling shares to raise capital because it needs funding to grow – or company insiders who are selling may believe that the environment for selling shares is at a point of maximum optimism, in which case they’ll get a better price (from a valuation perspective) than they would otherwise. Like everyone else, the people who are selling want to “sell high”. And investors buying into an IPO are betting that the company’s growth prospects are still strong… and that they’ll be proven to be “buying low”.
Who knows best? The danger of being wrong is that you buy an offering when the company is hitting all cylinders, and things can’t get any better… in which case, they can only get worse.
3. Is the company profitable?
If it isn’t, let’s face it: You’re not investing – you’re speculating. That doesn’t mean you shouldn’t buy the IPO, but it does suggest that the risk associated with the offering is higher. And you should account for that higher level of risk accordingly.
When you buy shares of an IPO in a company that’s losing money, you’re also putting an enormous amount of trust and confidence in management’s ability to pull off their plan to bring the company to profitability.
4. Are the shares expensive or cheap?
The shareholders who are selling will want to sell at the highest valuation level (that is, on a price-to-earnings basis, for example) they can. Investors buying into the IPO, meanwhile, will want a low valuation so that there’s room for the share price to rise.
The big question – as with any valuation exercise – is what the stock is being compared to. The people selling the IPO (that is, the bankers for the company) will focus on comparables that trade at high valuations – so that the shares they are selling will appear cheap by comparison. The shares of companies that are direct competitors in the same country and sector, with a similar growth rate, to the company that is going public are generally the best comparables.
Even then, the company hoping to sell shares will weave a story to explain why their shares should be more highly valued. If you believe it, then the shares will have less room to rise before they trade at a premium to comparables. And that means you have less upside to your investment.
5. Can I get shares if I want to?
To get shares in an IPO, your broker has to be part of the IPO, or else have a relationship with the banks that are. And most brokers tend to keep their IPO allocations (at least those for which demand is greater than supply) for their “favoured clients” – customers who trade with large sums of money.
So underwriters and “big investors” tend to have the first bite… and individual investors are often left with the crumbs from the table, or with the shares of a dud offering. To paraphrase Groucho Marx, would you want to buy shares of a company that has shares available to sell to you? Probably not.
6. What about fees?
Not long ago, investment banks made a killing on initial public offerings. They could earn around 7 percent of total proceeds, though that could vary according to the size of the deal. In effect, that meant investors were only getting 93 cents of value for every dollar that they invested in a deal.
Thankfully (for investors), that’s all in the past. Today, fees charged by investment banks are a lot more reasonable… closer to between 3 and 5 percent. So this isn’t really a factor from an investment perspective. But do bear in mind that your broker will stand to make a lot more by selling you an IPO than by just selling you a stock that’s already trading.
7. What rights will you have as a shareholder?
Traditionally when companies issue equity to shareholders, those shares come with voting rights. “One share, one vote” used to be the conventional wisdom underpinning corporate governance. But that is now changing, especially in the technology space.
Google (now known as Alphabet Inc.) led the charge in 2004 for what has become a common practice in technology IPOs of issuing dual-class shares. For example, with Google, they issued Class A common stock for new investors with one vote per share. But founders retained Class B common stock which carried ten times the number of votes per share.
Likewise, Facebook did something similar. But the most egregious recent example of this kind of voting structure occurred with the Snap Inc. IPO. In that case, new investors bought shares with absolutely no voting rights whatsoever. In fact, because of the way the IPO was structured, nearly 90 percent of control is retained by the 27-year old founders.
As an investor, you need to ask yourself if you are comfortable with companies taking investor money, but not giving investors any say in how the company is run at all.
If you’re looking at investing in an IPO, get answers to these questions first. And if it sounds too good… it probably isn’t true.
Publisher, Stansberry Churchouse Research
P.S. Investing in IPOs can be an exhilarating experience, given the promise a newly listed company usually brings to the table. But if you’re looking to get the wind behind your back by investing in strong companies in a growing market at reasonable valuations… see our presentation here.