IPO investing: What you should look out for

It is easy to get caught up in the IPO fever, but do your financial homework to avoid getting burnt


IF THE performance of nine initial public offerings so far this year is any gauge, retail investors continue to be attracted to the potential quick gains from IPOs.

All nine were oversubscribed and despite the recent market correction, eight of the stocks are still trading above their issue prices.

For instance, China-based Sihuan Pharmaceutical Holdings Group launched its IPO on March 23 with an offer price of 43 cents. It was 198 times oversubscribed. Last Friday, the counter closed at 64 cents.

It is easy to understand why IPOs are popular. They enable investors to profit from booming businesses both in Singapore and abroad, and to diversify their investments.

Investors can also gain access to a larger variety of industries.

Out of the 60 IPOs last year, 25 came from China, and there were offerings from South-east Asia, India, South Korea, Australia, Europe and the United States.

However, IPO investing is also fraught with risks.

'It is misleading to believe that when one gets shares upon listing, one immediately makes money. Homework needs to be done,' said Mr Joseph Chong, the chief executive of financial advisory firm New Independent.

Billionaire investor Warren Buffett once said: 'Generally, IPOs don't come at a time which is good for you - it's normally good for the sellers.'

The following is a list of what one should look out for in IPO investing:

Prospectus

THE prospectus may look dauntingly thick but it cannot be ignored. The important sections to read up in a prospectus include 'management experience' and 'risks and prospects'.

It is easy to get caught up in the IPO fever and invest blindly.

Investors should have a good grasp of the business as well as understand the valuations of the investments.

Financial ratios

NUMBERS are very important too. Look out for the share price to earnings ratio, the share price versus net asset value per share, the dividend policy, gross and net profit margins, returns on equity, and the debt to equity ratio as well as the average growth in sales and profits.

These figures will give a better idea of whether the company is enjoying net profit growth while generating a good return on equity with a stable capital structure - without being overly reliant on debt.

Usage of IPO proceeds

AVOID IPOs where a large portion of the proceeds is to be used to clear debt.

Financial planner Dennis Ng said he would be put on red alert if the bulk, say 80 per cent, of funds to be raised is meant for repaying bank borrowings, with the balance for working capital and expansion.

'For such IPOs, the firm usually has a very weak financial position and may be tapping into the public's funds primarily to improve its financial position,' he said.

Market sentiment

WHETHER the business environment, at the point of listing, is contracting or expanding has a significant impact on the IPO's initial price performance.

Past experience has shown that IPOs generally perform better in an expanding economy when investor sentiment is confident and bullish.

When times are tough, only quality firms tend to achieve a price premium over their IPO price on their market debut.

Earnings track record

BE WARY of firms that decide to get listed after posting a record performance in sales and profits.

There is always the danger that the pre-IPO accounts were presented in the best possible light to attract investors.

The question to ask is: Are such financials sustainable in the longer term?

Said full-time investor Ang Hao Yao: 'Check the profit track record for the past three years. If the recent year shows a sharp spike in profits, then the business may be of a volatile nature.

'One rule of thumb is to average out the three-year record to estimate the longer-term profitability. If the company is still attractive after the above assessment, then you can consider applying for the IPO.'

Pricing

MOST IPOs at their offer prices have a share price that is between seven and 10 times their earnings per share - a key indicator of share price performance.

The lower this ratio, the better value the share price offers in terms of profits generated.

'The offer price of some IPOs can be many times above the actual worth and does not represent value.

'For example, if the price earnings ratio is above 16, it's considered expensive,' said Frontier Wealth Management director William Cai.

Strategy: Buy and hold or stag?

MR NG said that he would buy and hold a stock only if he had confidence in the future of the company.

But 'stagging' - or selling the IPO shares on the first trading day - is another matter.

'I would 'stag' a company if I weren't confident about the company but...I was confident that the bullish market sentiment made it likely that the share price would be higher than the IPO offer price.'

A more cautious Mr Ang said he would not encourage 'stagging' because it is more speculative than investing. 'I would recommend that investors stick to applying for stocks they do not mind holding on to even if they fall below their IPO prices.''

Outlook for IPO market

A BULLISH UBS head of investment banking for Singapore and Malaysia, Mr Patrick Lee, believes that this year's volume of IPOs will eclipse that of last year.

Last year, 60 IPOs on the Singapore Exchange (SGX) raised a mind-boggling $7.6 billion, which was 25 per cent more than in 2005.

Among IPO managers, UBS raised the most money last year - US$902 million (S$1.37 billion) - followed by DBS Bank.

The five IPOs that UBS handled last year included several of the largest listings: Babcock & Brown Structured Finance Fund (US$246 million) and Banyan Tree (US$230 million).

UBS is now handling two IPOs and has a 'healthy IPO pipeline' for the rest of the year.

UBS and DBS Bank are the joint lead managers for one of China's biggest shipbuilders, Yangzijiang Shipbuilding, whose IPO is on track to become Singapore's largest so far this year.

And more choices are in the offing, with IPO experts forecasting many more fixed income-style IPOs, such as real estate investment trusts (Reits), rather than equities.

'The reason is that the foreign merchant banks have finally realised that there is a really huge Singdollar deposit base in Singapore that is extremely hungry for 4 to 5 per cent interest-yielding papers.

'And they are structuring many innovative interest instruments to tap the cheap Singdollar to fund their clients. Of course, the risk is borrowers' default,' said Westcomb Financial Group deputy chairman Choo Chee Kong.

Despite the recent market correction, DBS Bank's managing director and head of equity capital markets, Mr Kan Shik Lum, believes that market sentiment is strong, thanks to strong liquidity.

He added that in a more volatile market environment, yield-driven structures such as Reits and business trusts will continue to do well.

'The SGX has carved a niche in Asia for such products, as evidenced by the strong after-market performance of such instruments,' he said.