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Should You Say No To IPOs?

The Motley FoolPeter Lynch, probably one of the greatest investors of our time, once said: “Whenever the Queen is selling, buy it.”

In that one pithy sentence, Lynch has managed to encapsulate everything that is right about flotations and all that is wrong when a company decides to sell its shares on the primary market.

Lynch made his quip at a time when the privatisation of state owned assets in the UK was all the rage. The flotations that were being touted by then UK government to the public were partly as a result of political ideology and partly because of a need to raise money.

Consequently, the flotations had to be seen to be a success in order that the government could pursue its massive privatisation agenda. Any hint that a flotation would fall flat could have jeopardised the success of future Initial Public Offerings of state-owned enterprises.

In judging the merits of any flotation, private investors should therefore try to take time to understand why a company would even want to sell its shares.

Consider the privatisation of Royal Mail, which underlines Peter Lynch’s sentiment about “The Queen Selling”. The Royal Mail flotation bore many of the hallmarks of a cash-raising exercise by the government. As a result, the shares had to be keenly priced to ensure a smooth sale.

We can argue until the cows come home whether the shares, which were priced at a flotation at 330p, significantly undervalued the business. With hindsight it looks as though they might have been. But we must not lose sight of the primary reason for the flotation – it was designed to raise cash for the UK Treasury. On that score, the Initial Public Offering has to be judged a success because it achieved precisely that.

The Royal Mail flotation also demonstrated an appetite for risk by private investors. Additionally, it showed that there was plenty of cash sitting on the sidelines looking for a good home. Consequently, it should not have come as a great surprise that more flotations, particularly from the private sector, quickly followed.

But just because a company has decided to offer to sell its shares to the public does not mean we have to apply for them.

As private investors we have to decide whether we would want to take part in any flotation. A good place to start is to find out exactly why a company would want to sell part of its business to total strangers. After all, a sale, no matter how small, would mean giving up some control of the company to other people.

A couple of good reasons might include a need to raise capital to pay down debt. A company might also want to raise capital to finance acquisitions later on. So, by joining the capital markets, a company can potentially access funds at some later date. Those are generally quite acceptable reasons for an IPO. But there are some not-so-good reasons too.

A questionable reason could be to simply cash in on investors sentiment. Coming to market to help enrich the owners of a business is often not a good reason to buy into a flotation.

There is nothing intrinsically wrong with the owners of a business wanting to realise the value of their investment. However, it can be a good idea to look at how much the owners are likely to make from the flotation. There are no hard-and-fast rules. But if the money extract by the owners from the flotation seems excessive, then it probably is.

Another good reason to avoid a flotation is if the track record of the business is not detailed enough for you to make a proper judgement on the performance of the business. This is particularly relevant to cyclical business.

Ideally you would want to know how the business has coped through the rise and fall of an economy in the past. With that in mind, the track record of how these types of business performed in previous economic cycles could be enlightening. Unfortunately, businesses generally like to paint themselves in a good light, which could also mean that details might not be that readily available.

The key to successful investing is to learn as much as you can about the companies that you plan to buy shares in. If you can describe in one short sentence why the company is floating, then that could help answer the question as to whether it could make good sense to invest in the IPO.

With many flotations, the odds are, unfortunately, stacked against new investors. So that makes it harder to determine whether flotations are properly priced.

You could if you wanted build in a wider margin of safety. Alternatively, you could just wait until the company has been on the market for some time before buying the shares.

Personally, I like the idea of a cooling-off period. It could help you distinguish between your genuine interest in the business and falling for media hype, which tends to be a hallmark of most flotations, if the promoters are doing their jobs properly.

This article first appeared in the Independent on Sunday.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.