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High-risk investments
Make money on new issues
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The
new equity issue market is all too often a casino in which the professionals
manipulate share prices to make themselves money. There are many victims.
But once you understand the game and play by the rules, you have a chance
of winning spectacularly. You should invest only selectively in
new issues, and preferably in a roaring bull market. |
How new issues are priced
New issues are priced
according to demand and not fundamental value. In a bull market where institutional
investors are competing for shares in every hot new issue almost regardless of
its quality, the issue price can be set far above
fundamental value, and it may rise higher. In a bear market the
issue
price is set lower, but even then the shares can fall further.
Retail investors
are at a disadvantage
For obvious reasons, the banks that organise a poor quality new issue will
not warn you off. They will welcome you in.
Retail investors
swell
out the order book, enabling banks to price a new issue higher than otherwise.
Let us now look at how you can assess a new issue, which may enable you to
avoid the poor deals.
Look for analysts'
biases
The bank appointed
as bookrunner to the new issue sets
the
price
range based on feedback during a
pre-marketing
of the deal to institutional investors. The range consists of the perimeters
within which the deal should be priced.
If the price range is made public, analysts may put several alternative forward valuations
on the company to be quoted, based respectively on a price set
at the lower-,
mid-
and upper-end of the range.
Such forward valuations are often based on the prospective PE
ratio or enterprise
value / EBITDA ratio compared with those of similar companies. Analysts
may also use discounted cash flow analysis.
When you assess analysts' valuations, be wary. The analyst working for the bookrunner
will have a good grasp of the company's business,
but the investment banking division of the same firm will have an interest
in promoting the company’s business. Regulations require that research
touted as independent is not influenced by the bank’s commercial interests.
Even so, look at the output of analysts working in the other firms as well.
Even unbiased prospective valuations can be wrong.
Until the deal is priced, you cannot be confident of any projected valuations. This is for four reasons.
- Prospective valuations, including earnings, can be unreliable.
- The price range set might be very wide.
- Banks involved in the flotation occasionally move the price range up or down
to meet changing demand levels.
- The deal may be cancelled or postponed.
Flip new issues. It is the biggest open secret of professional investing
New equity issues often rise to a high in early secondary market trading, then plummet. Here is a secret. Institutional investors often make money because they flip the stock, buying and selling it quickly. You should often do the same.
This is not the advice that investment professionals will give you.
The banks want private investors to stay in new issues, seeing them as useful
for holding up the share price in secondary market trading. Do not be the fall
guy.
New issues in
foreign companies
The London Stock
Exchange is becoming increasingly international. It has marketed itself successfully
to companies in Russia, China, Australia and elsewhere. Many foreign companies
are joining the Alternative Investment Market in a dual quotation where they
remain quoted in the home country. Some are joining London’s main market.
The introduction of the stringent Sarbanes-Oxley Act in the US as an emergency
piece of legislation in reaction to the Enron collapse has meant many foreign
companies prefer to raise capital in London than in New York. You can invest
in foreign companies on the UK stock market, which is far less risky than investing
in local markets, through a local broker.
The investment risk is
significant. If you invest in a company with Russian banking assets, you
are exposed to the country’s weak and inefficient
banking sector and this is riskier than investing in UK clearing banks. Large
Russian companies often have risk warnings in their prospectuses. Corporate
governance does not have much of a tradition in Russia, and companies have
to pay over the odds to attract non-executive directors with Western experience
in the job.
If you can buy shares in
an IPO (or later in the secondary market) in a Russian or other foreign company
cheaply enough to compensate for the risks, it could
be worthwhile. In the case of Russian companies, valuations have become much
higher than in the aftermath of the country’s 1998 economic and market
collapse.
Read more about new issues now
For more about how
new issues really work, read The Times:
How the City Really Works, by Alexander
Davidson, published by Kogan Page.
For practical
advice on investing in new issues, read The Complete Guide to Online Stock Market Investing, by Alexander Davidson,
published by Kogan Page.
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