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Shiny new stocks
Never mind Google. Money managers are finding value in a wide range of IPOs. But is the cycle about to turn?
The IPO drought is well and truly over. Last year 250 U.S. companies went public, about the same number that did so in the three previous years combined. What's more, the new-offering terrain looks fertile.
John Fitzgibbon, editor of IPOdesktop.com, a Web site devoted to IPO research, reports that in the first two months of last year, 38 companies with a combined market capitalization of $3.9 billion went public; in the first two months of this year, there were 40 filings worth an estimated $5.6 billion.
IPOs can be alluring investments -- and not just for flippers, who typically unload shares on the first day of trading after their initial surge. Kevin Marder, chief market strategist of New Yorkbased brokerage firm Ladenburg Thalmann and Co., studied 153 recent IPOs and found that they returned an average 50.35 percent between January 1, 2003, and February 4, 2005. By contrast, the Standard & Poor's Corp.'s 500 index rose 36.7 percent over that period. Moreover, only 17 of the 153 (which had to be priced at $12 or more and trade at least 100,000 shares a day to qualify for Marder's tally) were trading below their offering price. The average loss was 11 percent.
"IPO shares have sustained broad market support based on reasonable fundamentals," contends Marder. Adds Robert Hoehn, director of research at Fulcrum Global Partners, a New Yorkbased independent research firm, "Investors are generally not overpaying for IPOs."
Nevertheless, Michael Balkin, co-manager of the Chicago-based William Blair Small Cap Growth Fund (whose three-year average annualized return is 22.5 percent), cautions IPO investors to expect more-modest gains in the future.
"We appear to be entering the last half of the IPO cycle, where we are seeing an increase in the number of weaker companies trying to cash in before demand for new issues slows down," says Balkin. Comparing the first nine weeks of 2005 with the same period of 2004, he sees more deals being pulled (12 versus three), lower first-day jumps (9.65 percent versus 17.9 percent) and a greater percentage of offerings being priced below their filing range (32 percent versus 23 percent).
IPOdesktop's Fitzgibbon calculates that the average gain of 26 IPOs that came out between January 1 and March 3, 2004, was 24 percent. The 37 offerings that came to market in the same period this year gained a more modest but still pretty darn respectable 10 percent.
"Last year at this time, the Nasdaq had a breeze at its back and was up 2.2 percent through March 3, 2004," Fitzgibbon notes. "This year the market is fighting a head wind, with the Nasdaq down nearly 5 percent." Yet, as he notes of the swell of new offerings this year, "that's hardly the sign of a sick IPO market."
Nonetheless, this volatile market is best approached with as much prudence as enthusiasm. Portfolio managers are focusing on new offerings in various ways. Timing a purchase can be as critical as timing the IPO itself. Ladenburg Thalmann's Marder prefers to let the trading noise surrounding a new offering quiet down before he steps in.
"This means waiting for a hot new issue to form its first trading range, or minibase, before buying," he says. "The sideways range serves to take some of the attention away from the stock, and as long as institutional demand remains -- especially when the stock attempts to break out, as it did with Google three weeks after its offering -- then that may be a good time to buy."
Blair's Balkin looks for a durable business model, a solid customer base to enable margin expansion, profit growth of at least 15 percent a year and -- here's the steepest hurdle -- reasonable valuation. He is especially attracted by young companies that are moving into a proven business.
For instance, Balkin has invested 1 percent of his $750 million fund in Kanbay International, a Rosemont, Illinoisbased outsourcing services company that has been generating 30 percent-plus earnings growth over the past six years by providing information technololgy outsourcing in India for U.S. companies. Balkin believes Kanbay could be another Cognizant Technology Solutions Corp. -- a similar company that went public in 1998 and has since become a market darling.
Kanbay went public on July 22, 2004, at $13, significantly below the $16 to $18 target price, as the market struggled. Proceeds from the $70 million IPO were earmarked for business development and infrastructure expansion, such as increasing office space. By year-end the stock had more than doubled; small caps, meanwhile, rose 23 percent in 2004. This year Kanbay's shares have pulled back to about $20, as the company's first-quarter revenue and earnings guidance and full-year projections were on the soft side. Balkin sees the correction as a potential buying opportunity.
Frank Sustersic, lead manager of the $430 million Turner Micro Cap Growth Fund, based in Berwyn, Pennsylvania, has invested 1.4 percent of his portfolio in Kanbay. He's bullish in part because two of Kanbay's biggest clients, Household International (a subsidiary of HSBC) and Morgan Stanley & Co., have stakes in it of 17 percent and 4.8 percent, respectively.
Sustersic, like many other microcap fund managers, stayed away from this year's much-ballyhooed Google offering, the biggest IPO since the Nasdaq composite index peaked on March 10, 2000. The Internet information purveyor's unusual auction format for the deal allowed retail investors to bid for shares in the primary market. Many institutional investors offered low bids, causing the IPO to debut well below its filing price range.
That set the stage for a major rally in Google shares, as institutions scrambled to buy shares in what they saw as the premier Internet search engine. The stock, which debuted at $85, hit a peak of $216.80 in early February 2005 before profit-taking drove it down to $180.88 in late March.
Mary Lisanti, who runs her own asset management firm, New Yorkbased A.H. Lisanti Capital Growth, a subadviser of the $5 million Adams Harkness Small Cap Growth Fund, searches for IPOs whose executives have created profitable companies before.
Case in point: Dr. John Simpson, who earned his MD from the Duke University School of Medicine and his Ph.D. in biomedical science from the University of Texas. The physician founded Advanced Cardiovascular Systems as well as Devices for Vascular Intervention and sold both cardiac technology outfits to Eli Lilly/Guidant. He also founded Perclose, which introduced the first suture-based arterial access site closure device; that company went public and was later acquired by Abbott Laboratories.
The doctor's latest venture, Redwood City, Californiabased FoxHollow Technologies, designs stents for peripheral arterial disease. These differ from most stents, which are designed for use in the thoracic region. FoxHollow is a top-ten holding in Lisanti's fund. The company went public on October 28, 2004, at $14 (raising $56 million), and the stock had risen to $29.29 as of late March.
"Here we have a company run by a man with a great pedigree who's developing a product whose use has largely been focused on coronary matters," says Lisanti. Although the company lost $1.36 per share in 2003, losses for last year are expected to narrow to $0.29 a share, and Listanti predicts that FoxHollow will be profitable by this year's fourth quarter.
Tom Taulli, co-founder of CurrentOfferings.com, a Web clearinghouse for new offerings, says that IPOs can be an effective way for investors to gain access to new markets that can be difficult to tap. He points to the $690 million mid-December IPO of Las Vegas Sands Corp., which owns the Venetian Casino Resort Sands Expo and Convention Center in Las Vegas. What made the offering especially attractive is that Las Vegas Sands is one of only three casinos licensed to operate in Macao, the former Portuguese colony that became part of China in 1999. A casino opened there in May 2004.
Las Vegas Sands went public at $29, well above the suggested $20 to $22 range, and soared to $54 by year-end. After profit-taking the stock was at $48.31 in late March.
Investing in seasoned spin-offs is an effective means of playing the IPO market, contends Patrick Dorsey, director of stock analysis at Morningstar. He points to Freescale Semiconductor, a Motorola spin-off that went public on July 16, 2004, at $13 a share and closed in late March at $17.26. The gain was driven by the prospect of further strong growth in revenue and gross margin, which came in at 17.5 percent and 38 percent, respectively, in 2004.
Like many big fund managers, J.B. Taylor, coportfolio manager of the Milwaukee, Wisconsinbased Wasatch Core Growth Fund, keeps a tiny percentage -- less than 1 percent -- of his $1.7 billion fund in new offerings. "It's not that one can't find attractive IPOs," he explains. "But the time required to do so simply doesn't justify the effort, because we usually cannot buy enough of the shares without significantly moving the market against us."
That's good news for the small fund manager looking for a sweet return.