Joel Gray

“Rising equity markets have seen the tide of initial public offerings (IPOs) rise as success breeds success and more businesses consider listing, but the lure of short-term profit taking can lead to disciplined investment processes flying out the window.”

This is the warning from Joel Gray, Portfolio Manager for award-winning investment manager, Hyperion Asset Management, who today acknowledged that rising markets and the liquidity they provide do encourage IPOs, as companies seek to capitalise on positive market sentiment.

“Hyperion has a fund which invests exclusively in Australian small caps, so we keep a very close eye on upcoming IPOs, because small cap stocks make up the majority of the listings,” Mr Gray said.

“It is well-known that companies often list at an initial premium, so the temptation is certainly there to buy in at the beginning and take the short-term gains,” he explained.

Mr Gray said that rather than looking to profit from short-term price hikes at listing, long-term investors, like Hyperion, would do better to analyse upcoming floats in the same way they would any potential stock, with a focus on the fundamentals and a long-term horizon.

“The excitement which accompanies an IPO can mean investors become carried away with positive market sentiment and lose sight of the value of fundamental analysis.

“In fact, we see the recent spate of IPOs as a good test of whether a fund manager will stick to a disciplined investment process, or succumb to the desire for short-term gains,” Mr Gray said.

Hyperion’s investment process focusses on the long term and takes the view that high quality companies will outperform over the longer term, and that sustainable earnings growth is key to success. Ultimately this means investing in growing businesses with superior economics, at an attractive price.

Mr Gray said that the key factors Hyperion looks for are a high return on equity, a proven track record of success, low gearing and organic, sustainable growth.

“This naturally cuts out a number of companies looking to list. For some it is because the listing is based on a promise of future success, and without a track record to judge by, we take the view that no matter how compelling the promise, we prefer to wait and see,” he said.

Mr Gray then explained that of the more than 50 listings which Hyperion had analysed over the past 12 months, only two had been chosen – OzForex, which offers an on-line, cost effective way of transferring international funds, and VEDA, the largest credit rating agency in Australia and New Zealand .

“In the case of OzForex, not only is the return on capital high, but return on equity is in the order of 60%, the company is debt-free and sales are growing at 30% p.a,” Mr Gray explained.

“And perhaps more importantly, we predict high growth for OzForex, which provides a quicker, cheaper option for transferring money overseas than the major banks.”

Mr Gray concluded by saying that a buoyant IPO market can certainly offer a rich source of potential investment opportunities, but investors looking for long term performance should exercise caution.

“Long term success can only be built on rigorous analysis of a company’s fundamental drivers of success, regardless of whether it is about to list or is an established market participant,” Mr Gray said.

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He shares his thoughts on why the outlook for earnings growth is more stable, and how an experienced small caps manager can capitalise on the opportunities this presents.

http://youtube.com/watch?v=-Ij892abvzk

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The majority of managers in the Lonsec small cap peer group considerably outperformed the benchmark in 2012.

The Lonsec Small Cap Australian Equity Sector Review observed that while small caps recorded a reasonable return, they again underperformed large caps for the year with the broader S&P/ASX 200 delivering a healthy rise of 20.3% for 2012.

“This trend is not unexpected given the more volatile nature of small companies compared to larger peers,” said Steven Sweeney, Lonsec Senior Investment Analyst.

“Small caps will tend to outperform larger caps in periods of more buoyant market sentiment while experiencing more downside weakness when markets are troubled.

“With risk appetite remaining relatively constrained, investors were more comfortable chasing high yield and defensive large caps during 2012 than venturing too heavily into small caps,” Mr Sweeney said.

Should risk appetite improve as appears the case in the current climate, it presents an opportunity for investors to revisit their small cap allocation.

Investment management team stability has been uncommonly positive in the past few years, a beneficial aspect of the bear market, with personnel more likely to be preoccupied with existing responsibilities versus eyeing greener pastures. The prevalence of boutique investment platforms in the sector with high alignment of interest and investment team buy-in has also improved stability.

One factor identified by the review as impacting small cap investment managers is declining market depth.

“Weak capital market conditions prevailed in 2012 with a lack of IPOs, capital raising and merger and acquisition activity limiting a traditional hunting ground for small cap managers,” Mr Sweeney said.

“The IPO market remains in drought and at cyclical lows for industrials. Indeed, 2012 was Australia’s weakest year on record for share market floats, which only totalled $876 million – down 32% from 2011, which was also a weak year.
 
“A dwindling of new opportunities suggests managers are increasingly hunting in a shrinking pool and looking for similar qualities in companies, resulting in a crowded trade scenario with the same companies being widely held.”
 
The Lonsec Review concluded the performance of the average small cap manager in the Lonsec peer groups versus the benchmark gives support to a meaningful allocation to small caps and an active investment approach.

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The review rated 44 headline funds, and a total of 96 product offerings. Seven funds were upgraded and two were downgraded. The report finds that the group remains highly competitive, with the average manager continuing to deliver performance well ahead of market benchmarks in recent years. 

Over the past three years the median manager returned close to 4.1% per year (net of fees) above the Small Ordinaries benchmark. The report also notes that the smaller capitalised end of the market is dominated by active bottom-up managers employing approaches that are less benchmark-aware compared to large-cap strategies. At the time of S&P’s review the rated peer group held an average of 32% in non-index exposure. 

Senior portfolio manager pairings form the backbone of most small-cap offerings, and highlight that key person risk remains prevalent across the sector. “It is therefore important that senior members display a healthy working relationship and encourage strong team dynamics,” said John Huynh, analyst at S&P Fund Services. “During 2011 notable departures were seen in the UBS and Macquarie teams, but there was stability across the remaining peer group which was underpinned by effective lock-in structures,” Mr Huynh said. 

The ratings distribution is concentrated in the four- and three-star rating categories, reflecting S&P’s view that the vast majority of funds in the peer group are capable of delivering risk-adjusted returns in line with their investment objectives. Only one fund, Aviva Investors Professional Small Companies, was awarded a five-star rating. The report notes that a number of top-tier capabilities, including those managed by BT and Eley Griffiths, were constrained primarily due to concerns about capacity.

The capacity issue within small-caps introduces a number of challenges for research houses, given the propensity for higher-rated offerings to attract a greater share of investor flows. “Highly rated offerings can quickly become hindered by strong growth in FUM, therefore we are naturally sensitive to awarding our highest rating to offerings which are at risk of being too large” said Mr Huynh.

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However the funds raised were down on previous years, according to the latest HLB Mann Judd Small Cap IPO Watch – click here  to read the report.

A total of 92 small cap companies listed over the 2011 year, up 10 percent on 2010 and 156 percent on 2009.  Small cap listings represented 88 percent of all IPOs during the year (2010: 88 percent, 2009: 92 percent, 2008: 93 percent).

However the total amount raised by small cap companies was down 17 percent on 2010, and the average level of funds raised by small caps was the lowest for five years, even at the height of the global financial crisis.  Small cap companies raised an average of just $6.84 million in 2011, compared to $9.07 million in 2010; $7.47 million in 2009; $7.45 million in 2008 and $8.75 million in 2007.

Mr Geoff Webster, author of the report and corporate finance director at HLB Mann Judd Melbourne, said that the decline in funds raised is a worrying sign of the ongoing challenges for listed companies and for corporate fund-raising generally.

“Coupled with the fact that 29 percent of 2011’s issues were undersubscribed, compared with 22 percent in 2010, it is concerning that the IPO market continues to struggle so badly.

“It is a further example of the difficulties businesses face in raising corporate finance and additional evidence of the challenging operating environment.

He also said that the start of 2012 looks set to continue the lack-lustre performance of the December 2011 quarter.

“The pipeline of upcoming IPOs is down from the same time last year, with only 26 ASX applications lodged seeking to raise a combined $122.2 million, compared to 34 companies seeking $321 million in January 2011.  Significantly, only five companies have a proposed listing date.

“On the other hand, the Australian sharemarket has started 2012 positively, and if this continues it seems likely that more companies will consider an IPO later in the year,” Mr Webster said.

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