Should you buy into IPOs? My Food Bag and Xero : good examples of froth versus substance : how to spot the difference

 

The shares mentioned in this blog are done so for illustrative purposes only, and comments made about them should not be used as a reason to buy, sell or hold the share.

An Initial Public Offering (IPO) is where a company or Government raises capital from members of the public (and institutions) by offering the chance to buy shares in a firm or State-owned enterprise. Cash in exchange for some ownership and control of the business.

Back in the 1980's Prime Minister Margaret Thatcher expressed her desire to make Britain "a share owning democracy", as she sold a number of State-owned enterprises. There were political and (pressing) economic reasons for her doing this and the legacy is a contentious one. However this may be the first major example of a Government actively encouraging the public to participate in IPOs.

There were huge advertising campaigns that anyone living in the UK at the time will remember. Such as the sale of British Gas with the "If you see Sid, tell him" series on television. Thousands of people then invested in the stock market for the first time. Similar privatisation campaigns occurred in other Western countries that decade, including New Zealand.

But is it a good idea to get involved? Is it responsible for a Government to encourage people to invest in the stock market when they may well have no knowledge of the implications? Should the man in the street buy into a company that they've heard of often and of whom they may be a customer, without knowing much of what is going on behind the brand name?

When a state utility (like Telecom) is sold, the price is always contentious. If in hindsight it is deemed to high, then investors sit nursing loses and blame the Government. If it is deemed too low, then the Government is accused of "selling the family silver" (as former UK PM, Harold MacMillan put it) too cheaply - short-changing the taxpayer to the benefit of the wealthy. There is no shortage of critiques of the New Zealand privatisation campaign of the 1980s, I found few that were favourable. This one from economists at Massey is quite unflinching.

In the case of British Gas one might argue that the State was certainly short-changed, as the price was estimated to have risen ten-fold after twenty five years. It's impossible to know for sure, of course, as one can't know how well the State-owned enterprise would have performed over that time.

What is more common, however, is the sale of a private company when it 'lists' on the stock market. Traditionally, a company sells shares onto the stock exchange in order to raise capital and grow their business. The alternative is to obtain financing from a bank. The stock market option is attractive as there is no need to repay the capital or pay interest. You do, however, have to give up some ownership and often control instead.

Increasingly, however, promising start-up companies have found a third way to finance their early stages of growth: Private Equity. The Private Equity (PE) financing model is an extremely strict process whereby professional investors offer support to a business owner for a limited period of time, typically five years or so.

The attraction of PE to the business owner is a large supply of capital and an avoidance of the reporting and regulatory requirements that listing on the stock exchange would entail. They also typically receive assistance from the PE investor in the form of introductions to firms and resources that can help the business grow.

For the PE investor, they expect to sell their stake for a considerable profit at the end of the agreed term. The manner in which they sell is normally by listing the firm on the stock market via an IPO. Obviously the higher the price that the shares are offered at, the greater the revenue received by the PE firm and the other initial investors. Aggressive (inflated) valuations of such IPOs led some witty commentator to say the acronym actually stands for "It's Probably Over-priced".

Searching for articles along this theme I found this one bemoaning the greed of well-known corporates that led to investors being "duped" by the Facebook IPO. The issue price was $38 per share. It quickly fell to a low of $17.73. Hence this article warning people that IPOs are bad news for investors. However nine years later Facebook's share price is $336 so clearly sometimes such cynicism is premature.  

Here in New Zealand there are two contrasting examples of an IPO proving a huge success and another appearing more uncertain.

The online accounting firm Xero is rightly hailed as an example of where an IPO and subsequent capital raising works well for all concerned. This article explains how after an uncertain start, things have improved dramatically. What is slightly amusing is that the article proclaims how well investors have done by that point (March 2013) as the share price had reached $10.70 whereas of course today they are trading at almost $138!

Conversely you have the example of My Food Bag (MFB). Here is a business that was far better known when it floated than Xero was. It had built up a large and loyal base of customers to whom it could market the share offering. Unlike Xero, the business model was tried and tested. It was perfect for the COVID-world of socially-distanced grocery shopping. Surely a safe bet.

So far, however, the story has not been a happy one for MFB investors. The issue price of the shares on the 5th of March this year was $1.85 and today they are trading at $1.45. A fall of 20% and the overall trend is still downwards.

Spot the dog

Could someone see in June 2007, with the markets frothy and the Global Financial Crisis just a year away, that Xero would in fact be a huge success? Possibly. Could you know in February that the IPO of MFB would (so far) be a failure? More likely.

What about the owners?

To my mind the major difference in the two listings is the approach of the owners themselves. 

With the Xero listing, the owners sold none of their shares. It was simply a capital-raising exercise in order to reap greater returns in the future.

With the MFB listing, the owners sold over 75% of their stake. For the PE firm (that had owned 70% of the firm) it is not surprising that they sold a substantial amount of their holding - as explained previously, this is simply part of the PE model. 

But the founders and other shareholders also sold a substantial part of their stake (probably three quarters of it). What does that say about their faith in the future of the business? Obviously these are early days and, like the article about Facebook, I could well be looking foolish in nine years time. However, all things considered I don't believe I will be (not least due to the might of MFB's international competitors).

For me that really sums it up. If an entrepreneur is effectively selling out, I'm not buying in. 

So far that simple rule of thumb has certainly helped me avoid some costly mistakes.

Dunotter disclosures

Disclaimer: This communication is purely meant as information for general interest. It is in no way to be taken as financial advice or relied upon in any way for investment decisions.