IPOs: Getting in the on Ground Floor

One of my biggest frustrations as an advisor at The Motley Fool was that I could not steer members into exciting IPOs at their float price. It’s a shame because IPOs are one of my favourite hunting grounds for disruptive growth companies.

Unfortunately, most members don’t have accounts with brokers that bring significant IPOs to market. The few that do are left to fight over scraps while fund managers and other institutional investors eat the lion’s share. They aren’t getting in on the ground floor of IPOs, missing out sometimes on very large gains.

Fortunately, a solution is in the works: Lakehouse Capital. Not only will The Motley Fool Australia’s new funds management business solve members’ biggest request — our saving them time and effort by doing the work of managing money for them — it will also give us a chance to get our investors directly invested into select IPOs for the first time.

The Big Draw

The initial public offering (IPOs) market is where you’ll find a fresh flow of disruptive ideas and new business models. One better, many of the companies are overlooked by big fund managers who either can’t or won’t invest in smaller companies.

Take Bellamy’s Australia. The organic infant formula darling came public in August 2014 looking for growth capital and a little liquidity for early investors.

Bellamy’s shares listed at $1 and finished their first day of trading at $1.31 — a handsome 31% one-day gain for those who participated in the IPO.

But the gains had only just begun.

The company used its IPO proceeds to expand deeper into Asia. It proved a masterstroke as Chinese demand for Australian infant formula exploded at the same time, sending sales, profits, and shares far higher.

Bellamy’s shares now sell for more than $14. That’s right: Investors who bought and held at the IPO are now sitting on a stake worth more than 14 times their purchase price, or a 1,300% return in just over 2 years.

It’s an extreme example, and whether Bellamy’s can keep up the pace is another question entirely, but it’s also a real example of what can go right in the land of small-cap IPOs.

The Good, The Bad, and The Ugly

I can’t emphasise this enough: Not all IPOs are big winners, let alone in positive territory. Some crash and burn.

Remember when a reincarnated Dick Smith choked on its inventory? Or maybe McGrath, which fell 12% on its first day of trading and then stumbled into a profit downgrade. It’s shares are off 43% since its December IPO.

Buyers must beware in the higher-risk, higher-reward IPO market. Especially now with a lot of downright speculative IPOs are coming to market. EM Advisory in May found that a shocking 45 of the 105 technology floats on the ASX over the previous year involved companies with revenue of less than $1 million.

But let’s invert that statistic: 60 new technology companies with more than $1 million in revenue listed within a year. Odds are good that some of those will prove winners given time, and I’m happy to carefully sift through the lot in order to find the ones that have what I think have the brightest prospects.

A Very, Very Specific List

We have very specific criteria when evaluating IPOs, and they go above and beyond our already extensive standard due diligence including site visits, competitive and financial analysis, and our proprietary checklists. A process that requires many hours days weeks of effort.

Specifically, we prize these above-and-beyond traits from our IPO investments.

Transparency on Key Operating Metrics. We’re always bullish on a lack of BS but especially when we’re on the other side of a seller with inside information. For example, when an acquisitive Link went public but neglected to mention it’s organic, ex-acquisitions growth rate. Silence can be deafening.

Engaged Founders. No one has more invested in a business — financially, emotionally, or reputationally — than its founders. Maybe that’s why empirical research shows that founder-led companies tend to outperform.

Founders having a large stake is important for another reason: it’s a tell that a company has outstanding economics and doesn’t need much capital to grow. It’s not a coincidence that some of the market’s greatest success stories — think TPG, Seek, Domino’s — have founders who still own massive stakes in the business.

Understanding Sellers’ Motivations. We’re happy to see companies raise new capital to fund logical, low-risk extensions to their existing businesses. We also don’t begrudge management and early investors taking a few hard-won chips off the table.

We don’t like situations where owners look to have dressed up a business for sale by starving it for capital, though, leaving public market investors to pick up the tab on revitalising the business. Another common tactic is to talk up long-shot, sexy-sounding growth opportunities that help to sell the IPO but end up quietly being swept under the rug as time goes by.

The Bottom Line

The ability to get investors on the inside track with high-quality IPOs is just one of many reasons I’m excited about Lakehouse Capital.

Joe Magyer, CFA
Chief Investment Officer

P.S. Another biggie is our ability to invest pre-IPO. Stay tuned.

The above article contains general investment advice only (Lakehouse Capital Pty Ltd is the Corporate Authorised Representative of The Motley Fool Australia Pty Ltd AFSL 400691). The Motley Fool owns shares of Bellamy’s Australia.