Be Early on the Capital Migration to This Corner of the Market

Pity the poor millionaire. It’s hard to make a billion with an Initial Public Offering (IPO) these days. It used to be that the founders of hot private companies could bank on an IPO to push their net worth above the billion mark.

A geometric explosion of wealth via an IPO is less and less common these days. But dry your tears for the struggling founders. It’s not that their fortunes are lagging, it’s just that the inflated valuations are happening in a different corner of the market.

A tsunami of capital has been burning a hole in the pockets of private equity firms, allowing high-growth companies to stay private longer and leaving fewer young companies eager to file for IPOs.

According to alternative investment research firm Prequin, assets under management (AUM) for private equity investments in early 2017 is double the $1.1 trillion in 2016. Take note; this is an additional trillion dollars looking for new investments, not billions. We’re talking a whole mountain of cash looking for a new home.

It’s no wonder that fast-growing firms like Uber and Slack choose to remain private. Outside of the public realm they have access to a seemingly unlimited stream of funding and can remain off the radar of public shareholders who judge them four times a year on quarterly performance.

The lack of sexy turbo-growth companies is partly to blame for a lackluster IPO market. Although the year to date count of 107 deals priced is on track to beat 2016’s dismal tally of 108, it’s hardly booming.

In addition to the fewer deals being priced, the early returns for IPO investors have been punk. On average IPOs have been up 12% since pricing this year, down from 16% last year.

The dearth of triple-digit returns for IPO investors has led to some ennui in this corner of the market. But like any market where supply and demand fall out of balance, there will be potential gains for those paying attention.

The current issue weighing down IPO gains is that new issue investors are missing out on companies earlier in their growth cycle. That supersized growth is what drives sky-high valuations. That 56,000% gain in Amazon and 1,600% gain in Google since their IPOs is linked completely to their uncommon growth.

There are two dynamics at work that can help the individual investor garner big gains by following IPOs:

The first is that the lower appetite for IPOs has forced underwriters to be a bit more discerning about what is served upon the IPO table. Investors are no longer willing to gobble down shares of every new deal regardless of its profitability.

This means that while many of the companies that file to go public are not growing revenue at high double-digit rates, many have solid business models and pragmatic growth plans.

The lack of excitement over IPOs also means that less money is chasing these deals when they begin trading. When institutional investors are frothing at the mouth to get their hands on an IPO, they often indicate to the underwriters that they will buy a certain amount of shares in the aftermarket, that is, once the IPO begins trading.

These buy orders often result in a frenzy of demand with too many dollars chasing too few shares. Trading revs up the moment the deal is priced and leaves little space for the small investor to get involved.

Recently many IPOs have opened with subdued trading. Of the deals priced this year, only a handful outside of the biotech area has opened with double-digit gains. Investors have the luxury of taking some time to research and analyze a new issue before jumping in with an open wallet.

The second trend that will take longer to play out will be the deceleration of private equity dollars available to invest.

Private equity investors are always looking for the final exit. Unlike the public stock market, investments in private companies are illiquid. The most common exit for private equity investments has been the IPO route.

But this route is not the easy gain that it used to be. The hordes of private equity dollars pushing up valuations of private companies make booking a big gain on an IPO less likely. Pair the huge private valuations with the conservative ones being applied to IPOs and the math doesn’t work.

Eventually, private equity investments will look for a new home if their returns are not sufficient. As this slow migration of capital happens, the cycle will reverse. Younger companies will look to the IPO market for liquidity and valuations will pick up.

In the meantime, I’ve found some terrific values for Profit Catalyst Alert subscribers in the IPO bin. One that I added in June is up three times the performance of the S&P 500 during the same time, and I’ve got a long list of others I’m analyzing.

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