Recent research showing that half of the share market's Initial Public Offers (IPOs) over the past 18 months are now trading below, and in some cases well below, their issue price provides a timely warning for all investors. Historically low interest rates and the 50 per cent rebound in share prices from the global financial crisis lows have increased the investors' appetite for more risky investments.
After the event, it's now clear that the time to buy and not to sell existing shares was in the gloomy aftermath of the GFC. Now, even though interest rates are likely to remain low for an extended period, the risks of adding to share portfolios are higher than they've been for several years.
Investing in IPOs involves higher levels of risk that need to be carefully assessed and compared with the alternative of adding to existing shareholdings. Many, but not all, of the IPOs are organised by private equity consortiums seizing the opportunity to take their profits and run - often overseas - with their money.
The standard operating formula of private equity groups is to strip out or borrow against assets owned by the companies they purchase, allowing them to increase the yields and dividends. As was clearly shown during the GFC, high levels of gearing can lead to company crashes or sharp falls in profit causing losses for investors.
The age-old question of why is this vendor selling an asset when its returns and prospects are so good? needs to be taken into consideration. The risks are further increased for investors purchasing IPO shares in heavily geared companies using margin loans.
Borrowing as a strategy to increase returns makes most sense when the returns and future capital value are relatively certain and most IPOs do not fall in to this category of investments. IPOs also face an additional and often neglected risk. This is whether the new issue will ultimately be included and remain in the key share market indices such as the ASX50, 100, 200 and 300 indices.
Unless the company obtains and retains a key index status, the growing percentage of managed indexed funds cannot invest in that company. Just how brutal an effect this can have on share prices was revealed in the past two weeks when, following its removal from a key share index, heavy selling reduced a biotech company's share price by 15 per cent. Even though this company still has encouraging prospects, its share price is now languishing at a much lower level. Such a price fluctuation illustrates the need for higher risk investors to be aware of all the factors that might affect the outcome of any investment, especially in new floats.