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initial public offerings

The operating profit of China’s Alibaba was 49 per cent of revenue in the second quarter of 2013, while U.S.-based e-retailer Amazon makes less than 1 per cent.Eugene Hosh/The Associated Press

With one of the biggest initial public offerings in history – Alibaba Group Holding Ltd. – eagerly expected in the months ahead and last week's dazzling debut of PrairieSky Royalty Ltd., the fourth-largest IPO in Canadian history, investors have to be wondering whether they should climb on the IPO bandwagon.

After all, the IPO price of PrairieSky, the Encana Corp. unit that allows investors to share in oil and natural gas production payments, was $28; the closing price after its first day of trading was $37. Its close Tuesday was $36.30.

And Alibaba, the mammoth Chinese e-commerce company, already has the kind of buzz that Facebook had when it announced it was launching an IPO in May of 2012. Facebook was priced at $38 (U.S.) but famously dropped more than 50 per cent in its first three months. Since then it has climbed to more than $60 a share.

"Right now we have a pretty frothy – or pretty happy – IPO market in Canada and the U.S.," says Craig Basinger, chief investment officer at Toronto-based Richardson GMP.

But a robust market goes only so far, he says. Investors have to take a close look at the company and its fundamentals – and even then, "there's some guesswork involved."

Understanding the company's fundamentals is crucial, says Jon Palfrey, senior vice-president at Vancouver-based Leith Wheeler Investment Counsel Ltd. It can also be hard work. Mr. Palfrey and Mr. Basinger say the investor's first job is to read the prospectus every company must provide before launching an IPO.

The prospectus can be long and detailed, but in many cases it's the only information out there for an IPO, Mr. Palfrey says.

It also means you are relying on information provided by the company itself, and while there are rules for what a company must disclose, "it's still absent the normal amount of information that investors would usually have at their disposal to make investment decisions," Mr. Palfrey says.

Eric Kirzner, the chair in value investing at Toronto's Rotman School of Management, calls it one of the major challenges of IPOs: asymmetric information, "or the fact that the company knows a lot more than you." Withholding critical information is illegal but it occasionally happens, he says.

More likely, Mr. Palfrey says, an investor has to read between the lines of the prospectus and glean the information that's truly relevant.

What to look for: Who owns the company now and why are they selling? Is it a case of divestiture or succession planning or private equity wanting to cash in?

"Some IPOs are privately invested companies and they've grown to the point where they want to tap into the capital markets and become publicly traded," Mr. Basinger says. "But a lot of others have come from a different angle, where they were publicly traded, and they were taken over by private equity and reformatted and rejigged and re-IPOed."

Mr. Palfrey says that when an IPO involves a divestiture, "you can see how the company has been performing within a larger public company." For example, Leith Wheeler participated in the PrairieSky IPO, he says, because his firm has been a long-term shareholder of Encana.

"We know the management involved in this asset. We can see the asset. We can have a very good understanding. It's not just hope and faith," he says.

Any company that is primarily based on intellectual property, research or soft assets involves some leap of faith, Mr. Kirzner says. "In some cases you don't even have an earnings stream as yet," he says. "And so you're buying into a concept, you're buying into an idea, you're buying into what's expected to be a future stream of earnings."

He cites the hypothetical example of a biotech company that goes to the equity market for financing. "You'd be buying into the possibility that this drug will be successful even years before it's going to be approved. It may be a good gamble – but it's a gamble."

Even in the case of Facebook, "no one really knew how to price it," Mr. Kirzner says about the 2012 IPO. "It was so complex and opaque … that's just a crapshoot."

For Mr. Palfrey, the decision whether to invest in IPOs such as Facebook, LinkedIn and Twitter – companies with high price-to-earnings ratios – also involves understanding just what kind of investor you are. If you are a value investor, "are you comfortable owning something that's trading at hundreds of times its earnings?" Probably not. But for an investor who prefers growth or momentum stocks, the prospect may be more attractive.

There's also the issue of fees. You don't pay a commission when you buy an IPO, but that doesn't mean there aren't fees involved. Brokers get incentives for selling IPOs. For individual investors, there's also the problem of availability: For a lot of the popular IPOs, the average investor isn't really given a chance to buy.

Mr. Kirzner is particularly cynical on this point. "If a brokerage firm thinks that a new issue is going to be a really good one, really hot in the after-market, who would they offer their allotment to? Their small customers or their more important ones?"

Mr. Palfrey agrees that investors have to be prepared to be disappointed in their allotment, but he adds that if they do get access they have another important decision to make: when to sell the stock.

Once stocks are freely trading, anything can happen – and investors need to be prepared for any eventuality. That's particularly true for hyped IPOs that face a rocky start in trading.

"Put a discipline in place," Mr. Palfrey advises. "Otherwise people just act emotionally and that's always a waste of time."