Five questions to ask when you are shown an IPO prospectus

Posted by Andrew Main 22 September 2016 @ 12:00am

1.  Why are they raising the money?

There are lots of good reasons why company managements offer shares, also known as equity, in new floats, but there are also some shaky ones out there too.

Are new shareholders going to be paying out previous shareholders rather than helping to grow the business?

The prospectus must identify where the money is going. If there is a vendor involved, that’s not an instant negative, but it would be better if they retained some skin in the game. Say a prospector is selling down an interest in a gold discovery. It’s absolutely usual for bigger companies to “farm in” as they call it, to mining prospects so they can be properly developed but you’d hope the original finder remains at least a minority shareholder.

2. Does the stock have an earnings record?

A lot of small miners don’t, which is why they are raising the money, but most industrial capital raisings should have some runs on the board. It’s no disaster if they’ve been reporting losses: almost all startups do that because of their set-up costs.

Even new issues involving smartphone apps and software will have accumulated losses at that point.

What you should look for in that case is that the losses should soon convert into profits. Back when the Chinese economy was being opened up in the 1990s many company promoters got carried away by assuming it was theoretically possible to sell one example of the new product to everyone in China. It was called the Billion Armpit theory. I remember with shame riding a front wheel drive bicycle around the foyer of a big Sydney hotel at that time, and hearing how it was going to revolutionize life in rural China. It had two gears, the higher one activated by pedaling backwards.

Last I looked, Chinese cyclists were still using rear wheel drive and the front wheel drive bike was lost in the mists of history. And no doubt the investors’ money went with it.

3. Do you understand the product?

Investment guru Warren Buffett always says if you can’t work out what it is doing, stay away, as lots of other people will have the same problem. He’s right.

That’s always going to be a headache with technology stocks but their promoters are no longer selling the blue sky in the way they did until the “tech wreck’’ of 2000. Promoters know that investors won’t fall for guff that makes their eyeballs throb, so if they have a good product they must explain it in simple terms.

Don’t just go for household names because you have heard of them. Two of the least exciting floats in recent years have been Myer and Dick Smith.

They gave a bad name to the private equity industry, which in both cases was selling out after supposedly adding value to the businesses.

Dick Smith’s management is currently having to explain to the administrators why they bought 12 years’ supplies of batteries from the manufacturers then claimed the rebates from the manufacturers as profits, before they‘d actually sold the batteries.

Myer’s looking a lot better at around $1.30 now than it was in 2015 when the shares dropped as low as 83 cents, but even now it’s a long way south of the $3.90  a share price that investors paid back in 2009  when the company was re-floated.

4. Don’t assume that because you don’t fancy some new device, that others won’t. 

I’m not given to jumping out of perfectly good aeroplanes, but one of the more successful new floats of recent times was Indoor Skydive Australia Ltd, which uses a blast of air from below to imitate the action of falling through space. The shares came on at 30 cents in late 2013 and even though they are only about 10 cents above issue price now, they cracked 70 cents in the interim, thus doubling the original investors’ money.

5.  Companies are nothing but a group of people who you hope are working together for the benefit of shareholders.

Have a look at the lists of people shown in the prospectus as directors and managers. Some small companies combine both roles in an executive chairman which saves money but leaves a lot of power with one person. Ask any of your friends who might know this person, and Google them. Do your due diligence on them, as the old phrase goes.  One piece of negative press may be a blip or a misunderstanding but a clutch of negative articles in different publications may be something else entirely.

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