IPOs: Buy Value, Not Stories

October 30, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments.

Everybody loves a good story. Stories entertain, inform and educate. They can also spur action, including among investors.

However, the problem is that stories often disrupt proper investing behavior, whether it’s building appropriate portfolios based on investment objectives or selecting individual securities to populate a portfolio. On the latter, security selection should primarily be about assessing an investment’s yield, the potential sustainable future growth in that yield, and its valuation. An expected return is derived from these building blocks, not the stories that surround them.

The IPO Story

Compelling stories attract investors to one area of the market in particular, “initial public offerings,” securities that represent the first sale of equity by a company to the public. These companies usually have a hot growth story to tell—and an expensive price tag to go with it.

Regretfully, because the story is so compelling, investors will often pay too much for an IPO. Various studies have shown, despite some sensational stories to the contrary, that IPO investing is typically a net loser for many individual investors.

There are valid arguments to own IPOs, including the benefit of having exposure to companies before they hit the major indexes. The exposure is truly unique for at least a short while (certain names don't ever hit the indexes). IPOs can also be viewed as an innovation play and provide indirect exposure to private equity.

2 Good Options For IPO Investors

Nonetheless, if one is going to invest in IPOs, a solid recommendation is to use an exchange-traded fund. ETFs are diversified and liquid—two attributes that many IPO investors do not get when they invest in individual securities. There are two strong ETF providers that currently offer domestic as well as international ETFs: First Trust and Renaissance.

First Trust had the first IPO ETF: the First Trust US IPO (FPX | A-74), which launched in 2006. This ETF has some rules that help limit some of the damage done to many individual investors. First Trust also has an international version, the First Trust International IPO (FPXI | F-44).

FPX buys IPOs and spinoffs on the sixth day of trading and holds them for 1,000 days thereafter. The spinoff addition provides an added benefit, but the most beneficial feature is the longer holding period. The fund also excludes companies that experience higher-than-average underpricing, essentially the largest first-day performers.

Renaissance Capital also has two ETFs, one for domestic ETFs, the Renaissance IPO (IPO | A-48), and one for international ETFs, the Renaissance International IPO (IPOS | F-41).

Renaissance IPO buys only IPOs on the sixth day of trading and holds them for just 500 days, and includes liquidity screens, but has no measurements for mispricing. The fund has also struggled to provide beneficial exposure since inception.

For investors attracted to IPO investing, these are great vehicles. For indifferent investors, such as we at CLS, they’re not favorites, at least not now.

These funds hold securities that are, on average, much more expensive than the overall market. Also, the underlying companies tend to be lower quality (i.e., less profitability, higher debt levels) than the typical stock.

Given our preference for higher-quality companies, particularly in this market environment, IPO investing is less attractive.

An Alternative To IPOs

One ETF we find attractive in the current environment invests in funds that are similar to IPOs but not quite the same: closed-end funds (CEFs). It is the PowerShares Closed End Fund Income Composite Portfolio (PCEF).

Like IPOs, CEFs are generally introduced with great fanfare, supported by strong sales and publicity efforts. Because of this attention, both stocks typically have strong price runs to start. IPOs see valuation spikes before faltering, and CEFs see price premiums to their net asset values before faltering. Once the initial promotion wears off, however, many CEFs begin to trade at discounts to net asset values. At this point, CEFs can become attractive.

CEFs might become even more attractive if the discounts get larger, like they are now. Recently, CEFs were trading at their steepest discounts in eight years. Unlike IPOs, which are generally expensive, CEFs are on sale. The fund we like, PCEF, takes advantage of discounts in CEFs.

That’s a story to get behind.

Grant Engelbart also contributed to this article.

At the time of writing, CLS Investments held a position in FPX and PCEF. CLS Investments is an Omaha, Nebraska-based third-party investment manager and ETF strategist. CLS began to emphasize ETFs in individual investor portfolios in 2002, and is now one of the largest active money managers using exchange-traded funds, with more than $2 billion invested. Contact CLS’ Marketing Communications Specialist Sadie Brewer at 402-896-7406 or at [email protected]. Please click here for a complete list of relevant disclosures and definitions.

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