Victoria Stevens

How to spot Economic Advantage in newly listed companies

Victoria Stevens

Victoria Stevens: How to spot Economic Advantage in newly listed companies

2017 was a busy year for IPOs (initial public offerings) on the London market – 106 of them raised £15bn in funds for the companies involved. Almost half of these (49) were via the AIM market, a 29% increase on 2016’s number of new companies.


This year has started more slowly, but we have still seen 15 companies join London’s main market (to end April), while AIM has welcomed 12.


On most occasions when we apply our investment process, it is to a company that is already listed on the London Stock Exchange. Here, we would be participating in the ‘secondary market’ – investors exchanging an existing stock of shares in a company. This is how we have populated the majority of our Funds – after all, there are 946 companies on the LSE’s Main Market and a further 941 on AIM to choose from.


The ‘primary market’ covers instances such as IPOs when we can invest in ‘new’ shares; this also includes placings and rights issues, where a company raises money by selling shares. While placings and rights issues raise additional funds for a company listed on a stockmarket, an IPO deals with the initial admission of a company’s shares to an exchange.


Investing in an IPO comes with its own unique set of challenges but we have found that the primary market has provided a good pipeline of potential investments for our funds, particularly at the small-cap and micro-cap end of the market.


In principle we apply exactly the same investment criteria to the assessment of IPOs as to equity available in the secondary market. In practicality, the typical profile of a company joining the market and the mechanics of the listing process do mean that there are some differences in the way we apply our investment framework.


For us to invest in a business, the first stage is to confirm that it possesses ‘Economic Advantage’ in the form of at least one of the three intangible assets we seek: recurring income, intellectual property and strong distribution networks. We need to gain an in-depth understanding of a company’s business model and characteristics to make a judgement on whether it possesses these intangibles. Our ability to make this assessment is largely unaffected by whether we are dealing with an IPO or established stockmarket listing. 


It is at the second stage of our process – seeking evidence of superior financial returns – that we encounter some differences. For currently listed companies there is usually a wealth of historic financial information and reports which can be delved into.


By contrast, a company approaching an IPO – while providing documentation including a comprehensive prospectus – will typically have less historic financial information available, especially if the business is itself relatively young. Historic balance sheet and profit & loss accounts may additionally need adjusting if the IPO proceeds will fund changes to the business or balance sheet – by paying down a chunk of debt for instance.


Despite the uncertainties created by the absence of a ‘track record’ as a listed company, there are compelling reasons to selectively participate in IPOs.


The most obvious attraction is valuation – this is the third step in our investment process.  All things being equal, shares in a company coming to market will be available at a discount to listed peers in order to provide compensation for the uncertainties. As the company proves itself over time, this discount would be expected to narrow. Investors willing to conduct proprietary research and meet management can therefore benefit from this risk discount narrowing – an opportunity that is not always available on the secondary market.


As well as a risk discount, another factor often leading to attractive IPO pricing is the desire of vested interests to “get it away”. If shares in an IPO are priced too expensively then they will be under-subscribed, damaging the credibility of the broker and leading to the IPO being cancelled, or postponed and reset at a lower level. This creates a bias to price IPOs keenly in order to attract interest, create over-subscription and raise the likelihood of the share price performing well initially.


A further appeal of IPOs is that they often enable investors to tap into new, emerging industries and ‘get in on the ground floor’. While this opens up the possibility of significant upside, it also requires a discerning eye to avoid investments with faddish or bubble characteristics which are aiming for blue sky returns but have little prospect of achieving them. Our investment process has built-in criteria which are designed to reduce the chance of exposure to these risky stocks – we only invest in profitable companies for example, and avoid those with weak balance sheets or an overaggressive approach to acquisitions.


It is safe to assume from the above that we are very selective in judging which IPOs to participate in. We turn down far more opportunities than we invest in, as only a few will meet our investment criteria. We also take a conservative approach via our risk scoring process, making sure any higher risks are reflected in a lower portfolio holding size. Nevertheless, the ‘primary market’ of IPOs forms a key component of our prospective investment pipeline. Overall, if we see evidence of Economic Advantage which is converting to good cash flow returns, we will then look at the pricing of the IPO to see if an attractive risk/reward trade-off is available and in some cases it will be. Of the 13 stocks we have added to the Liontrust UK Micro Cap Fund over the last year, four were via IPOs.


Historically, some of our funds’ most consistent performers have been sourced via IPOs. Craneware is a great example, having entered our portfolios on its stockmarket flotation in 2007. Craneware is the largest provider of pricing and billing systems to American hospitals and is a relatively rare instance of a stock which possesses all three of the intangible assets our Economic Advantage investment process looks for. Since then, it has been more than a “16 bagger” in investment jargon – on a total return basis, with dividends reinvested in the security, it has made investors more than 1600% over the course of a decade*.


*Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. 

For a comprehensive list of common financial words and terms, see our glossary here.

Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. The issue of units/shares in Liontrust Funds may be subject to an initial charge, which will have an impact on the realisable value of the investment, particularly in the short term. Investments should always be considered as long term.

Some of the Funds managed by the Economic Advantage team invest primarily in smaller companies and companies traded on the Alternative Investment Market.  These stocks may be less liquid and the price swings greater than those in, for example, larger companies. The performance of the GF UK Growth Fund may differ from the performance of the UK Growth Fund and will be lower than its corresponding Master Fund due to additional fees and expenses.


This content should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Examples of stocks are provided for general information only to demonstrate our investment philosophy.  It contains information and analysis that is believed to be accurate at the time of publication, but is subject to change without notice. Whilst care has been taken in compiling the content of this document, no representation or warranty, express or implied, is made by Liontrust as to its accuracy or completeness, including for external sources (which may have been used) which have not been verified. It should not be copied, faxed, reproduced, divulged or distributed, in whole or in part, without the express written consent of Liontrust. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Wednesday, May 9, 2018, 9:53 AM