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Aug 02, 2019

Beware of recent big IPOs, caution fund managers

‘Hot’ floats are like ‘buying a lottery ticket,’ warn small-cap specialists

Most of this year’s big name IPOs will have lost investors money within the next five years, predicts Dutch-based global small-cap investment specialist SilverCross.

There have been a flurry of major-name companies with big floats this year, including Uber’s mammoth $82 bn listing and Beyond Meat’s sizzling IPO, which has proved to be the best performing flotation of the year, as well as WeWork, setting up for a big September IPO – in what has amounted to the most active period for IPOs since the heyday in the late 1990s.

For all that, Chris Andrews and David Simons, co-managers of the highly ranked SilverCross Global Small-Cap Fund, put a different spin on the situation, warning investors they should be cautious.

In SilverCross’s most recent quarterly report to investors, the managers say investing in ‘hot’ IPOs is like ‘buying a lottery ticket’.

‘Investors are clearly attracted to IPOs, and the key difference now is that companies coming to the market have existed on average for 12 years versus only four in 1999,’ the managers note. ‘We avoid them, not because we don’t believe in their business models or their growth potential, but because of a combination of the valuations of these businesses in relation to the risks involved as well as the fact many have never made a profit.’

These IPOs translate, warn the managers, ‘into highly speculative investment propositions’. Putting this statement into historical perspective they note: ‘In the period 1980-2016, almost half of all IPOs had lost more than 50 percent of their value within five years, while another 20 percent had lost up to 50 percent of their value.’

In addition, only five percent of all IPOs had a five-year stock price return exceeding 400 percent, ‘so investing in these businesses is more like buying a lottery ticket,’ assert the managers.

Andrews, whose fund has returned an impressive 122 percent to investors since launching five years ago – versus the MSCI World Small Cap Index’s return of 64 percent – says the team’s investment process means they steered clear of these ‘hot’ IPOs.

‘We look to own between 25-35 small-cap companies globally which have strong long-term track-records, robust balance sheets and typically enjoy recurring demand for their products,’ Andrews says. ‘We want management teams to be invested in the equity of the companies they run, and we like family-owned businesses because their long-term approach fits with ours.’

While skeptical about the number of IPOs in 2019, Andrews nevertheless adds that the notion that stocks are in bubble territory is misplaced, with the price-earnings ratio of global small caps now at 20 times – versus the 20-year average of 29 times.

‘Although there are pockets of the market that may be overheated, given our concentrated portfolio we continue to find compelling investment opportunities,’ he notes.

‘The companies we invest in each aim to contribute to making the world a better place, and we invest in companies that make products or deliver services that people need, rather just like to have or use. This offers resilience during more challenging economic times, which may or may not come in the next 12 to 24 months.’

Highlighting this in detail Andrews highlights how global stock markets have declined strongly twice in SilverCross’s history when the fund’s resilience showed its worth: between April 2015 and February 2016, the China market crash and concerns of the pending end of quantitative easing in the US drove the MSCI World Small Cap Index down by 25 percent. But SilverCross declined by just 12 percent.

In the most recent market setback at the end of 2018, the index fell 22 percent, versus 15 percent for SilverCross.

‘Market declines are inevitable,’ notes Andrews. ‘We maintain a consistent and disciplined approach and do not worry about market declines. Instead, we use them as opportunities to buy great businesses on sale and hold them for the long term to benefit from the power of compounding. Time in the market, not timing the market is what drives wealth creation.’