Portfolio Manager Perspectives

Jeff Benjamin

Should IPOs be treated like a separate asset class?

One IPO fund manager — Josef Schuster — explains how to break down any new entrant

Feb 10, 2011 @ 3:10 pm

By Jeff Benjamin

There is renewed life and strong momentum in the IPO market, but investors should not ignore some fundamental realities and patterns that newly public stocks tend to follow, according to Josef Schuster, manager of the Direxion Long/Short Global IPO Fund Ticker:(DXIIX).

Mr. Schuster’s fund, which he manages on a subadvisory basis for Direxion Funds, currently has 110 long and 105 short positions based on that strategy.

As founder and chief executive of IPOX Capital Management LLC, he believes that newly public companies generally experience three stages of development during their first four years after going public.

The first stage, he explained, is the “15% to 20% pop on the first day of trading,” if the company goes public at close to its original offering price.

After the close of the first trading day, the second stage extends for the next 12 to 18 months, during which newly public companies can trade out of sync either with the market in general or other stocks in the same sector.

“During the first year the stock prices are not driven by fundamentals because there is usually not a lot of history and very little analyst coverage,” Mr. Schuster said. “We are typically long the stocks during this period because they typically outperform the market.”

One example is NXP Semiconductors Ticker:(NXPI), a semiconductor producer that went public Aug. 6 at $13 per share, and has since gained 104%.

This compares with a 17.7% gain by the S&P 500 over the same period.

When an idea works, as in the case of Hyatt Hotels Corp. Ticker:(H), Mr. Schuster will let it ride on the long side.

Hyatt, which went public Nov. 5, 2009, at $27 per share, has since gained 82%.

The third stage of the IPO cycle, generally from the end of its first year through the fourth year after the IPO, is when Mr. Schuster starts looking for companies to sell short.

This is the period when much of the initial hype starts to die down and stocks will often experience declines, he said.

“You need to treat IPOs almost as a separate asset class during those first four years of trading,” Mr. Schuster said. “For example, as part of the IPO the companies can receive a lot of cash, but it’s what they do with that cash that’s important.”

The portfolio is currently 20% net long, but one of the short positions is American Water Works Company Inc. Ticker:(AWK), which went public April 23, 2008, at $20 and is now trading at around $26 per share.

With nearly 2,000 companies around the world having gone public over the past four years, Mr. Schuster’s strategy does require some fundamental analysis to pick long and short positions.

And long positions don’t automatically become short positions after the first year of trading, but companies are moved from the long to the short screen after the first year, he said.

Lately, the strategy has been a victim of momentum in the IPO market, which has seen an uptick in new offerings, particularly in the United States.

Last year, the U.S. accounted for 154 of the 279 global IPOs, but so far this year all 20 IPOs have been U.S.-based companies.

“The Hong Kong IPO market has dried up, and the U.S. is now leading the global IPO market for the first time in more than two years,” Mr. Schuster said. “It’s really an interesting development and it shows how institutional investors are getting more confident about U.S. deals.”

Portfolio Manager Perspectives are regular interviews with some of the most respected and influential fund managers in the investment industry. For more information, please visit InvestmentNews.com/pmperspectives.


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