How to profit from a red-hot IPO market

The volume of new issues is dizzying. Here's the most important factor in deciding whether a new stock is worth your money.

By StreetAuthority Dec 19, 2013 1:17PM
Hilton Hotel, Midtown in New York
© Andrew Kelly/ReutersBy David Sterman                                                                 

Across the country, investment bankers are catching up on their sleep. They've been remarkably busy helping a stunning number of companies go public over the past two months.

The IPO docket should now be quiet for the next few weeks as the market digests more than 50 IPOs that were launched since late October, according to Renaissance Capital. And that only counts deals underwritten by top-tier firms such as Goldman Sachs and Merrill Lynch.

The flurry of activity caps off one of the busiest years for IPOs in recent memory. Dealogic notes that 166 companies have raised $64 billion thus far this year. To put that in perspective, there were never more than 80 IPOs in any given year from 2006 through 2011, and around 120 last year.

The volume of secondary offerings this year (in terms of number of deals and dollars raised), is also on track to break records.

And these aren't no-name companies stepping up to the IPO trough: Household names such as Hilton (HLT), Extended Stay America (STAY), The Container Store (TCS) and of course Twitter (TWTR) have all come public in just the past 60 days. Here's a closer look at the recent deals, with an eye toward how to play this trend.

Strong gains
Of the 52 IPOs that were priced since Oct. 24, only seven have lost value. Indeed, some of these deals have delivered scorching returns.

                                                   Source: Renaissance Capital

Frankly, it's hard to spot value in such high-fliers for one simple reason: Their investment bankers set their offering price at a level that reflects comparable value to their peer group. As a result, none of these stocks would be considered to hold relative value, simply based on the metrics deployed by the underwriters.

Indeed, some of these high-fliers can't even be measured by traditional metrics. When Twitter began trading, I noted that shares already looked overvalued. Yet shares keep surging to fresh all-time highs, and it's hard to square the company's $33 billion market value with sales and profit forecast even three or four years out. This has become an "own at any price" stock for some investors, which can be a dangerous way to invest.

The trades 
Before trying to identify which stocks look like solid long-term investments, we can look at which new issues might make for good trades. These are the stocks that have been public for less than 25 business days and will soon be the recipient of fresh analyst coverage.


Of course, any stock that is already up more than 30% or more from the offering price is unlikely to get an analyst price target that is much higher. And any deals that raised less than $100 million are unlikely to have enough analyst coverage to move the needle.

Look for hotel chain Hilton as an example of a stock that will get a solid "analyst pop." To sell more than $2 billion worth of shares, and in light of the hotelier's still-high debt load, the deal was apparently priced at a modest discount to peers. Yet such highly indebted companies are typically a favorite of analysts, as cash flow over the next few years helps to pay off some debt, allowing the multiples to expand as risk lessens.

The investments
To my mind, the only recent IPOs you should consider are those that have gotten off to a slow start, and as a result, still hold value. Some companies simply need more time to build a following. I talked about this approach last month with regard to homebuilding materials supplier Ply-Gem (PGEM), which traded down after its IPO to deep value territory. Shares are now getting better traction, yet they still are undervalued.



Yet as noted, many IPOs have already rallied sharply, and the list of struggling recent new issues is fairly short. Indeed, only one-third of the deals priced within the past two months are still trading for less than 10% above the offering price.



So why do some deals simply fail to resonate with investors? A troubled path to profitability is often a culprit. Investors have shunned textbook rental firm Chegg (CHGG), for example, as that company loses a huge amount of money thanks to depreciation. The company is able to generate moderately positive cash flow when that depreciation is accounted for, but not enough to satisfy value investors.

You'll also find a lot of dividend-paying master-limited partnerships (MLPs) in this group, which is not a surprise. These MLPs will never be high-fliers due to their controlled rate of growth, so the key is to find which ones represent impressive dividend yields at current prices. However, that's a tricky exercise in light of their limited track records as public companies. Equally important is a focus on how these MLPs can boost their dividends over time.

The good news: Many of these recent IPOs are still several months away from their next quarterly report, giving investors plenty of time to determine what the eventual dividend streams are expected to look like. This is where the analysts' reports will come in handy, as earnings models reflect input from management in terms of profit structures, growth initiatives and payout potential.

In coming weeks, I'll be focusing on the best IPO bargains from the class of 2013. For now, I'll just quickly focus on my favorite way to invest in IPOs: exchange-traded funds (ETFs). My colleague David Goodboy recently profiled the First Trust IPOX-100 (FPX), which only holds IPOs (after a seven-day waiting period) that weren't the beneficiaries of huge pops on their first day of trading.

I'm also intrigued by the recently launched Renaissance IPO ETF (IPO), which has a 0.60% expense ratio and is up less than 10% from its offering price. The passively managed fund tracks an index developed by Renaissance that focuses on recent IPOs, and should provide a diversified approach to the broad number of new issues that have recently come to market.

Risks to consider: IPOs carry considerable risk in the mid-term, as newly public companies often rein in growth expectations a quarter or two after the IPO euphoria has faded. Moreover, these stocks are exposed to the 180-day lockup rule and can see heavy selling from insiders at that point, especially if shares have generated huge gains already.

Action to take: The old rule of thumb surely applies: If you get in on the offer price of an IPO though your broker, then you should buy it. But if a recent IPO has surged out of a gate, then patience is advisable. Though some of these IPOs can still move much higher, many of them come back down to earth as peer-based valuations start to matter again.

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