It is common for companies to list on the Australian share market to raise capital required for future business plans, or in the case of Telstra to pay down government debt. Given the billion-dollar float of QR National, it is an appropriate time to examine how an investor might analyse a float and determine a risk/reward relationship for such an investment.

If you are considering whether to buy into a float, or to wait until after the shares trade on the market, here are some tips on making an informed decision.

First, irrespective of the reasons why a company floats, it is important to understand that all floats, in my view, are higher-risk investments and should be treated as such. Until someone is willing to part with their money it is difficult to assess the real price or demand for a company's shares. The mistake many people make is to become emotionally attached to the story being sold to them about the company. This is particularly likely if they use the company's products or services, or have received share investment advice from someone they perceive to be credible.

There are many examples on the share market of well-known companies, large and small, such as Telstra, NRMA and AMP, that have floated at a particular price before falling shortly afterwards. Statistics prove that more than 50 per cent of all floats trade below their initial price 12 months after listing. Therefore, picking the 50 per cent that go up can be a bit of a gamble and it is imperative that you do your homework.

No meaningful data to chart

Assessing a float from a charting or technical perspective is impossible before listing simply because there is no data to assess, other than the float prospectus as required by law. The majority of the information in these documents on how to invest is mainly marketing hype which is designed to get you to part with your money, and so are next to useless.

I have always believed the devil is in the detail and this rings true in the case of some company prospectuses. That said, the prospectus is the only document that provides the fundamental information, knowledge and background on the company, and we are expected to rely on it to determine whether to invest.  

In assessing a float, I suggest you move past the fancy pictures and marketing and head straight for the financials to form your own view about how realistic the forecasts are. Also read commentary by experienced analysts who are not connected with the float in any way, and stay clear of analysts from brokering houses that are involved, either through conducting the float or being given an allocation of shares to sell.

Given the historical hit and miss nature of floats, I often find it is better to wait until the shares have traded on the open market before investing, even if this means entering at a slightly higher price. This has two benefits: you can more easily assess the demand for the shares, both fundamentally and technically, which provides the opportunity to enter with a higher probability of making a gain; and second and most importantly, you are less likely to enter into a company that is sold off after the float.

Why is this so important? If the shares are falling away, you are losing the opportunity of being in another company that is rising in value, or having your money in the bank earning interest. If a share falls by 10 per cent, it needs to rise in value by around 11 per cent just to break even; a share down by 50 per cent (Telstra) needs to grow 100 per cent to break even.

Therefore, buying shares after the float is likely to reduce the risk of loss and does not add much to your costs for the odd occasions where you pay a little extra to enter.

The big five

Below are charts of some well-known companies that were floated on the Australian share market by the government several years ago. They are CBA, Telstra, CSL, Qantas and Tabcorp.

(Click image to enlarge)

Commonwealth Bank                                     Telstra                                                                  CSL

Qantas                                                            Tabcorp

The charts only look at share price action for the first 12 months after listing, not price movements since then or latest prices. They are not meant to show whether the share is a good buy now, but rather how it traded in the first 12 months as a listed company.

You might think these would be the best, safest and most transparent of all floats for anyone to have bought into. What I have found is that government float or not, shares generally will exhibit similar characteristics post-float. Note the data on some charts has been adjusted for corporate actions and so price may not be exactly the same at the time or after the float. The important observation to make is what unfolded after the float.

Of the five charts, you will notice that apart from Telstra, all could be bought below the opening price in the days, weeks or months following. This shows that waiting can save you time, money and lower your risk. What is difficult here is to calculate the correlation between the actual float price and the opening price on the market, because the data has been adjusted. However, in general I have observed that the initial opening price tends to be within a few percentage points of the float price for two reasons:

1.    New investors are often loath to pay more than they could have through the float.

2.    Some investors in the float attempt to 'stag', or capture a profit by selling immediately or soon after the float.

At the bottom of each chart you will see high volume being traded early on, which is indicative of some investors selling shares to capture a profit, and market participants such as managed funds buying to lift their weighting in the company. Trading activity was amplified with both Telstra and CBA early on because only a percentage of the total value of these companies were sold as part of the initial float. This meant less supply and so price rose until supply met demand.

After that period you can see that price either levelled out or fell away, with the time taken for this to occur differing for each share.

Long wait with Telstra

Telstra is a good example of a poor investment in a float, especially the T2 and T3 floats that occurred sometime after the first part of the company (T1) was sold off. In both these cases, investors experienced only a brief rise before a dramatic fall over many years. Although T1 rose strongly for at least the first 12 months, those who bought into this part of the float are also now holding a losing position.

You will notice that Tabcorp fell away for three months before rising, and Qantas, CSL and CBA could have been bought six or 12 months after the float for a similar price.

The reality is that determining before their debut which floats will be winners on the share market is very hard, especially when your decision may be swayed by tax, dividend or other incentives, as offered with T3.

We all like a ‘good buy’ and do not want to say goodbye to our money. My rule is to not buy shares in a float and to wait until I can assess the company trading on the market.

For further stock market information I suggest you listen to a podcast by one of my Senior Analysts called ‘Company Floats: A Good Investment or a Marketing Exercise? Part 2’.

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