Avoid hype & follow fundamentals in resurgent European IPO market
The improved political and economic environment in Europe has encouraged a pickup in initial public offering (IPO) activity over the past 18 months, especially at the smaller end of the market, as companies look to capitalise on the upbeat market sentiment.
Roughly €28.3bn in new company listings have been launched during the first three quarters of 2017. However, investing in companies at IPO is a subject dividing investor opinion. For some, an IPO offers early access to exciting young companies and the potential for substantial rewards. For many others, the risks associated with investing at IPO are perceived as being stacked against investors, limiting any prospective rewards.
Within the T. Rowe Price European Smaller Companies Equity strategy, we have been an active participant in the IPO market, taking part in 12 new IPOs in 2016 and a further 19 over the first 10 months of 2017. These have been across a range of industries, such as disruptive online consumer-facing companies – in fields as varied as pharmacies, fashion, and mattresses – as well as innovative health care providers and multiple companies looking to capitalise upon recent technological and service breakthroughs. This gives an indication as to the number of quality European businesses now looking to list on the market.
Be cognisant of the multiple IPO risks
However, for every successful company IPO there are plenty more that are not, where share prices quickly sink below the IPO issue price, sometimes dramatically, and investor capital is destroyed. This high rate of disappointment highlights the multiple risks associated with the IPO process.
Firstly, the seller decides when to exit. The person or people selling the company are the ones deciding when to exit their investment and take it public. What separates the good sellers from the bad, however, is that they recognise that an IPO still needs to be priced reasonably to be successful. An overpriced IPO, resulting in a sharp decline in the share price, can be difficult to recover from.
Secondly, there is the risk of the company being managed for the short term. The decision to take a privately owned company public is often made years before an IPO is ultimately announced. The good sellers are those focusing on long-term growth, rather than short-term results. They do not see the IPO as simply the end goal, but rather as an opportunity to raise finance to continue the next phase of the journey as a public company.
Finally, the information advantage is against investors. It is hard enough to gauge the fundamental quality of an established company, with years of public accounts to pore over, let alone a private company where little information or historical records tend to be available. Investors are at a clear information disadvantage when it comes to an IPO, with the accompanying prospectus as the only real source of information.
Ignore hype and follow fundamentals
While there is less information available on a private company, compared with publically listed counterparts, with experience and resources it is still possible to gain a good level of understanding of a company in the lead-up to an IPO. Comparisons with similar public companies in the same industry or sector can provide a good baseline of information, particularly as a guide to valuation multiples being assigned to competitors. In addition to company comparisons, an IPO valuation depends heavily on the company’s future growth projections. Growth is a significant part of value creation, so an assessment of the company’s plans and projections for future growth is critical.
The harsh truth about IPOs is that the actual fundamentals of the business are often overshadowed by the hype and excitement around the business. It is important for IPO investors to have a firm and through understanding of the facts, and the associated risks, and not be distracted by a flashy story promising great rewards. History shows the best medium- to long-term performances from IPOs tend to come from well-established, ‘durable growth’ companies.
Although ‘concept’ stocks can be exciting, they typically do not feature on the list of best-performing IPOs. Lower-quality companies also tend to fare poorly, as do companies with commodity exposures.
The risks associated with the IPO process, and the short-term mind-set of many investors, means that the potential for value destruction is high. That is not to say that good, even great, growth opportunities cannot be found, but investors must be prepared to do the research, assess businesses on their merits, and value them accordingly. With a longer-term investment horizon, we believe investing in quality companies at IPO can potentially deliver exceptional rewards.
Ben Griffiths, portfolio manager of the T. Rowe Price European Smaller Companies Fund