The Prudent Way To Profit From IPOs!

``I guess it's true that some people simply don't have the stomach to think big thoughts, let alone take big actions. The ultimate nightmare for such people is waking up some fine morning only to discover that they're going in the opposite direction from where the mainstream is headed. To people with a lemming mentality, acceptance is more important than money, dignity, or purpose. Which is unfortunate, because success and the desire for acceptance are mutually exclusive objectives.”-Robert Ringer, Making Ripples

The Prudent Way To Profit From IPOs!
-Prevalent IPO Fallacies: Confirmation Bias and the Greater Fool Theory
-Fundamental Analysis or Rationalization?
-Market Cycles Determines IPO Activities Over the Long Run
-IPOs Over the Short Term: "It’s the Market Sentiment, stupid!"; Lessons

The Prudent Way To Profit From IPOs!

As the Philippine benchmark, the Phisix, continues to set fresh record highs, a stream of Initial Public Offering (IPOs) have been set to take advantage of the public’s burgeoning appetite for Philippine securities. And with several scheduled to list in the coming weeks, we get a flurry of queries on these.

With the prevailing perception that IPOs represent the quickest way to earn money, such desire to secure allocations occasionally creates a friction between clients and their brokers on the former’s access to available IPO shares.

It should be understood that member-brokers of the Philippine Stock Exchange are prorated shares in accordance to the allocation as determined by the candidate company undergoing the IPO process under the supervision of the Philippine Stock Exchange (PSE).

It is then the brokers who assign the distribution of the partitioned shares to their clients. Plainly put, given the traditional role, the brokers have the discretionary power to ration IPO shares to their clients according to their priorities.

Amidst the prevailing buoyant sentiment exuded by the market, the reality is that NOT everyone can be pleased.

However, because of this bottleneck, several companies undergoing IPO have tried to accommodate small retail investors through a special arrangement or via the “small investors program”, where retail investors can directly or indirectly subscribe from the company or through a designated non-broker conduit.

Anyway, despite the hubbub generated by the IPOs, our assertion, once again going against the conventional wisdom, is that buying IPOs for short term gains is a SPECULATIVE undertaking, unworthy of the anxieties that emanate from securing shares to subscribe. Moreover, as we will show the best returns from IPOs DO NOT COME from short term gains!

To quote Porter Stansberry of Stansberry & Associates (highlight mine), ``Speaking of IPOs... Buying them is a fool's errand, if you don't get the broker price – which you can't get unless you've got tens of millions of dollars in your account or you're plugged in. Market studies show that, on average, buying IPOs on their first day of trading is one of the worst ways of investing.”

Prevalent IPO Fallacies: Confirmation Bias and the Greater Fool Theory

IPO’s by definition means the first sale of stock by a company to the public (investorword.com) or specifically a private company’s channel to raise capital by the sale of its shareholdings to the investing public.

The procedures of the IPO itself requires the company to disclose all attendant risks that the prospective investor could likely assume, as indicated in the preliminary prospectus or the “Red herring”.

However, since the main thrust is to raise money by the sales of its shares, then obviously the plus or the selling points and NOT risks get to be emphasized. The likely analogy is that of the fine prints usually found in contracts, which are hardly ever read by the contract signatories which only come into their awareness when a conflict occurs.

And naturally, in order to generate public interest for the raise funds via the IPO route, the company undertakes a marketing campaign. Media blitz, Road Shows, and other related activities are conducted here and abroad. But since the core of MOST of the offerings are designated for overseas investors, so does the thrust of the marketing campaign.

In other words, good publicity combined with warm reception from the international investing community frequently lead to a “buzz” in the local sphere which prompts for a surge in the local market participant’s demand for the IPO.

AND MOST importantly, in the backdrop of spiraling prices in the market, as signified by the ecstatic Phisix, as well as elevated prices of companies belonging to the same industry, further reinforces the impression that such investments are impervious to risks. Subsequently, the average investors thus draw a conclusion that the prospective IPO would inarguably go nowhere but UP…especially over the short term!

Here, as we have noted before, the fallacy where average investor equates rising prices as representative of “fundamentals” is much pronounced. In addition, their perspectives have been apparently shaped by projecting the recent performances as tomorrow’s outcome, known as the “Recency Bias” or the “rear view mirror” syndrome.

As an example, let me cite you the common threads asked of us on the upcoming IPOs:

1. What do I think about the IPO?
2. How will the market receive the IPO?
3. Will there be opportunities to make short term gains?

Where our natural response is that we can’t see how IPOs perform over the short term as they are most likely to be DETERMINED BY THE PREVAILING SENTIMENT UNDERPINNED BY THE MARKET CYCLE, and that over the short-term the RISKS DIMENSIONS ARE FAR GREATER with respect to the market’s general dimension…unfortunately we get the Rodney Dangerfield treatment-“we get no respect”, simply because our answer DOES NOT FIT what they had actually expected to hear!

The first question was never really of any relevance or importance because it was a question designed to lead to a discussion on the known “fundamentals” as they have most probably gleaned from either the media, their social circles or from broker reports.

What these prospective investors would like to hear is a confirmation of their belief, where we recall Julius Caesar invaluable words, ``Men in general are quick to believe that which they wish to be true.”

And our expected role as a person from within the industry was to actually validate on such views! And to talk of something beyond what is expected was tantamount to blasphemy!

As a student of the financial markets we understand this fallacy as the confirmation bias or where one looks for circumstances to confirm one’s beliefs, or (wikipedia.org) ``the tendency to search for or interpret new information in a way that confirms one's preconceptions and avoid information and interpretations which contradict prior beliefs.”

In essence, people simply want to believe what they need to believe regardless of the validity of the basis of their beliefs.

The second issue is to deal with expectations particularly that of the short term dimension.

Basically, except for the insiders, information disseminated from an IPO company are usually almost evenly distributed, where both long term investors and short term speculators obtain similar data and profile as dispensed by the company through their prospectus.

What distinguishes the investors from the speculators is the time frame expectation in terms of holding on to a security or in this case the IPO.

In the norm, like long term investors, speculators often cite “fundamental” reasons to justify their actions.

However unlike the long term investors, instead of the rating securities based on valuations, they are predisposed towards tuning into the surrounding hype and the prevailing market action from which, they assume, would allow them to sell to a BIGGER SUCKER once the IPO gets listed.

This investing approach is commonly known as the Greater/Bigger Fool Theory or from wikipedia.org (highlight mine), ``the assumption that they will be able to sell it later to "a bigger fool"; in other words, buying something not because you believe that it is worth the price, but rather because you believe that you will be able to sell it to some one else for an even higher price.” In short, this approach essentially epitomizes gambling. You go into a position in the hope that someone else will subsidize your bets.

Likewise, the average speculator never ruminates about the other side of the trade, i.e. if there is a willing seller there should be a willing buyer at an agreed price. If they sell, who would be the buyers?

What if, despite the media sensation and present buoyant conditions, a significant majority of the IPO subscribers turn out to be short term punters, where most expect to unload of their holdings upon the company’s initial listing date? And in contrast to expectations, when the company debuts in the stock exchange, a paucity of investors or “Greater Fools” surfaces instead. The likely scenario is that the IPO share prices would DROP towards its offering price or could even trade below them!

And since falling prices runs counter to the average speculator’s mindset, especially by those who cannot accept their mistakes, this would entail a sudden departure from a short-term perspective to a “long” only position. Our spurned punter then turns into a buy-and-hold investor!

To put in categorical perspective, does anyone ever recall of how major telecom player Digitel Telecommunications Philippines which listed on November 27, 1996 at Php 3 per share NEVER popped beyond its offer price (as shown in figure 1)?

The company’s share prices even lost more than 90% of its value (a low of about 26 centavos) during the trough of the recent bear market! Today, DGTL trades about HALFWAY from its 1996 offer price!

Figure 1: Digitel Communications: Never Seen the IPO Sunlight!

This is not to say that the conditions we cited above had been applicable to Digitel; that would be speculation on our part.

But the fact is DGTL’s listing came at the peak of the bullish cycle (Phisix reversed in first semester of 1997), where its unfortunate timing resulted to its failure to breach its listing price and consequently suffered a loss for both the investors and speculators alike, especially by those who were in denial about the state of the market’s cycle.

Could these happen again? Of course it can…or it will, if and when the market cycle turns.

As finance guru Jay Ritter says of the investing in IPOs, ``The IPO market is never in equilibrium. It's either too hot or too cold. Buy in the cold periods.”

Fundamental Analysis or Rationalization?

The third fallacy goes with the “fundamental” excuse to justify one’s activities.

As we have noted above, the average investors most probably in the league of speculators or momentum traders tend to use “fundamentals” to justify entry positions and exit based on “intuition”.

Take for instance an investor obsessed with the Price earnings ratio. Let us assume that company ABC presently priced at 10 pesos per share has earnings of Php 1 per share, which effectively translates to a Price Earning ratio of 10. The company expects an average earnings growth rate of 10% a year.

Because our average investor/speculator thinks that such PE ratio is “cheap”, Company ABC is then added to his/her portfolio at current prices.

Then for no apparent reason, sometime in the future, the share prices of Company ABC is bidded up to Php 11 per share. Our investor/speculator having seen a 10% gain decides to take profits because he/she “feels that the price has risen and therefore subject to fall”.

If going by the “fundamental” reasoning, an earnings growth of 10% implies earnings per share at Php 1.1. So at the market price of Php 11, essentially the PE ratio remains the same. So why did our investor or speculator sell?

Because the actions taken to enlist one’s position had been simply an effect of “rationalization” or (wikipedia.org) ``the process of constructing a logical justification for a flawed decision, action or lack thereof that was originally arrived at through a different mental process.” (highlight mine)

This is the sort of convoluted reasoning is so widespread in the marketplace. It is the same kind of misaligned thinking that usually leads to portfolio disasters, simply because market participants manifests the lack of focus and discipline in their investing approach and allow ticker directed impulses to dictate on their decision-making process.

Market Cycles Determines IPO Activities Over the Long Run

If the function of the IPO is to raise capital for a private company by selling its shares to the public, then obviously the best time to facilitate such activities is when the markets are RECEPTIVE. Accommodating conditions allow for the company to sell their shares with relative DISPATCH at the same time get MORE value for them. So our question, when is this?

Figure 2: PSE: IPO TRENDS follow Market CYCLES!

Figure 2 gives us an indication of IPO activities. IPO activities (bar) tend to rise as the Phisix (line) goes higher and vice versa.

During the peak of the previous market cycle (1994-1997), companies that went public ranged from 13 to 22 a year. When the market cycle reversed as shown by a declining Phisix (1997-2002), the number of companies that took on the IPO road slowed to less than 5 a year.

Today as the Phisix transits deeper into the advance phase of the contemporary market cycle, we hear of more and more companies considering the IPO path. To quote the Philippine Daily Inquirer, ``Several companies are also raring to list shares. There’s Northwind Power Development Co., which operates a wind farm in the northern province of Ilocos Norte; ethanol fuel producer San Carlos Bionenergy Inc., based in Negros Occidental province; PNOC Alternative Fuels Corp., a biofuel unit of state-owned Philippine National Oil Co.; and Enerfuse Holdings Inc., also a biofuel producer.”

It’s a brewing IPO fever. And such is what to expect, upcoming hysteria from the IPO landscape as the Phisix goes higher!

IPOs Over the Short Term: "It’s the Market Sentiment, stupid!"; Lessons

Our earlier premise was that IPOs represent as “one of the worst form of investment” over the short term because it is usually treated as an alternative form of gambling.

This is premised on the difficulty of predicting market sentiment on the inaugural day of the company’s listing, where we painstakingly described above of the attendant perceptive fallacies commonly adopted by the “crowd”.

Figure 3 tell us that despite the all the rationalization about fundamentals, market sentiment weighs HEAVILY on the performance of an IPO company on its launching season.

Figure 3: Fundamental driven IPO Successes??? In your Dreams!!!

Since the onset of the millennium, the largest IPO offerings (in pesos) according the PSE to date had been (in pecking order):

1. SM Investments (Php 250 per share, listed on March 22, 2005, offer amount Php 28.75 billion),
2. PNOC Energy Development Corporation (Php 3.2 per share, Dec. 13, 2006, Php 16.696 billion),
3. First Gen (Php 47, Feb. 10 2006, Php 8.503 billion),
4. Manila Water (Php 6.5, Mar. 18 2005, Php 4.845 billion),
5. National Reinsurance (Php 3.8, April 27, 2007, Php 2.424 billion) and
6. Banco De Oro (Php 20.8, May 21, 2002 Php 1.852 billion).

The reason for this list of the IPOs is to put into perspective the so-called “fundamentals” usually broached by the average investors. The largest IPOs consist of the companies with known “fundamentals”.

And because the common assumption is that fundamentals drive IPO successes over the short run, we take into consideration of 3 issues that has operated in different time frames or in distinct stages of the market cycle as shown in Figure 3.

First is Banco de Oro, listed in 2002 at Php 20.8 per share, as shown by the leftmost arrow, represented by the black candle chart. The superimposed green line is the Phisix, while the red trend line denotes of the interim trend of the Phisix during the listing date.

BDO suffered a decline below its offering price during its debut to close at Php 20.75 and even lost a further 25% to a low of Php 15.5 three months after! This came as the Phisix slumped to its cyclical nadir in 2002.

After a year BDO even fell further to its ALL time low at Php 14.75. When the Phisix manifested signs of recovery, BDO broke above its offering price only in November of 2004 or more than two year after it listed!

Today, BDO is about 246% above its IPO price. Was BDO then, a showcase of “fundamentally-driven” short-term success?

Second is utility stock Manila Water, seen in the blue line whose listing date is similarly marked by the red arrow.

I purposely chose to chart MWC over SM Investments (not shown in chart), where both had almost simultaneously listing in March 2005, because UTILITY firms are often reputed abroad as “defensive” issues which usually outperforms on a countercyclical basis or during market or economic downtrends. Unfortunately so, as the chart indicates MWC did not manifest or operate as Utilities are known to function when the Phisix corrected.

Anyway unlike SM which traded immediately BELOW its offering Price during its debut, MWC for the first two days closed on a slight PREMIUM. However, as the chart shows, the declining Phisix (falling red trend line) once AGAIN weighed heavily on the two “fundamental” firms.

Remember at this stage of the cycle, the Phisix has already been navigating on the advance phase (drifting at the 2,100+ level after a steep run up). But the offering came at such a bad timing (both in March) which was coincidental to the massive corrective wave (also in March) and led to a dismal start.

Relative to the offering price, MWC fell or lost 14% to a low of Php 5.6 per share three months after, while SM fell to a low of Php 191 per share or a loss of 23% six months after!

Could SM and MWC serve as examples of “fundamentally” driven short-term success??? Obviously not!

When the Phisix bolted out of its previous high during the last quarter of 2006 or about one and a half year after the listing of MWC and SM, both companies breached their offering price levels to trade at a premium today of 96% and 80% respectively.

The recent best one day performer among the IPOs has been the listing of Pacific Online last April 12, 2007 where its share prices stormed by over 50% above its offering price of Php 8.8.

I won’t exactly categorize this issue as of the same “fundamental” caliber relative to the securities cited above, would you?

The rightmost chart shows LOTO, as signified by the violet line, in conjunction with the overtly bullish sentiment exuded by the Phisix (rising red trend line and downward arrow). So far LOTO trades about 73% above its offering price.

ALL other IPOs or secondary offerings from listed companies during this year have traded conspicuously ABOVE their offering prices simply because the Phisix has been on a tear up 26% year to date!

Such OVERWHELMING evidences basically demolish the argument that “fundamentals” drive stocks higher over the short-term! Not in the Philippine setting, anyway.

Some important lessons gleaned from the aforementioned experiences are:

1. IPOs are NO different than the REGULAR listed issues. They operate under the auspices of the market cycle in all time frame dimensions (short, medium or long term).
2. IPOs are NOT exempt from risks.
3. Recent activities DO NOT guarantee an IPO’s success.
4. While corporate fundamentals count, market sentiment MOSTLY determines the short term success of IPOs. But since short-term movements are hard to predict, it’s anyone’s guess how the IPOs perform over the short-term.
5. The best returns in an IPO experience does NOT arrive by second guessing what an IPO does during its listing date but by comprehending on the whereabouts and conditionality of the present phase of market cycle and by taking appropriate action based on these circumstances.
6. Like all forms of prudent investment, an enforceable exit strategy or contingent plan should be employed.
7. Benefit from a RISING trend by nursing one’s gains while reducing losses and finally,
8. Avoid falling for perceptive fallacies; conduct your own detailed investigation on the merits of the investment.

In 1992, the controversial presidential campaign slogan coined by Democratic Party Strategist James Carville which was carried by ex-US President Bill Clinton became widely used today...It’s the economy, stupid!

Allow me to paraphrase this quote in the context of IPOs over the short term, “It’s the Market Sentiment, stupid!”