IPOs Yield Healthy Returns For Those Braving The Risk

Research backs up the impression that the IPO market is doing well, according to IPO specialist firm Renaissance Capital. The company recently made public its new IPO index, which represents 95% of the IPOs of the last two years. Year to date, the index's return stands at 15.9%, double the S&P 500's return in the same period. The number and volume figures this year seem set to make 2007 the biggest IPO year since the tech crash in 2000.

Still, the IPO business is always more volatile than the market at large. There have been disappointments in post-debut performance this year, especially from much-ballyhooed financial companies like Blackstone Group (NYSE: - ) and MF Global (NYSE: - ). And in August the new-issue market suffered from the credit crunch that hit so many other stocks.

Kathleen Smith, a principal at Renaissance Capital, spoke to IBD about the new index and what can be learned from tracking total IPO performance over time.

IBD: Why did you decide to release the index now?

Smith: We've been working on this index for quite a while, so it's really a question of completing the work we've done on it.

As soon as (companies) go public, they enter the index and then exit the index after two years. That's the period of time when we feel that they are unique companies. It's a category of companies with low float, not well-researched initially.

If you look at an index of IPOs, you realize there are unique returns that you can get. Some studies show that an IPO index can provide alpha to a portfolio. It's mainly because IPOs tend to be an area underrepresented in major indices, and they often can take companies and industries that have yet to appear in other indices. So it's usually in the world of IPOs that new industries manifest themselves. You might see the solar cell industry, for instance, (or) on-demand software. An index of IPOs will capture the new industries coming up that will become significant parts of established industries.

IBD: Why are IPOs underrepresented in other indexes?

Smith: The challenges of doing such an index is trying to get a correct assessment of the float, and to be able to know the characteristics of the companies. There's no research or earnings estimates out on them, so we do the research.

Certain specific things happen to IPOs that don't happen to other companies. More shares may come out due to the overallotment option. A lockup is very big for the IPO -- typically 180 days, but it varies. And these companies often have secondaries.

On the research side you can put together an index, but it doesn't help much if you can't tell what the P-E ratio is, what the growth rate is, (or) what the sales are. When you're dealing with companies that are brand-new, a lot of those data are not available. So we were able to use our database from researching every one to understand the characteristics of our index.

IBD: The conventional wisdom about IPOs is that they follow the general performance of the stock market. What's your observation on that?

Smith : The beta's higher. When the S&P's up, (the index is) up more; when it's down, it's down more. But if you look at it over time, you'll find that the real returns are higher. If you risk-adjust it, you'll find you get better returns. It's worth the risk.

IBD: Turning to the pipeline, it looks like some alternative asset managers are coming along. This year, those kinds of companies have gotten a lot of attention, but they've been disappointing in the aftermarket. What should we expect out of that?

Smith: We think that they're not going to be the place to be from an IPO standpoint. We think investors are starting to look at growth companies, and not growth as a result of financial engineering. Investors are beginning to focus on technology and emerging companies, which is a little bit more the bread and butter of the IPO market over the years.

IBD: Yes, tech seems to be bulletproof. Should we be worried that there are some big pops coming from companies that aren't making money?

Smith : Our studies are showing the average first-day pop for IPOs is less than 15%. So that's still within the range of norms.

There is a lot more interest in technology now and in the IPO market. If you look at the statistics, it's a good time now for the IPO market. Companies are lining up and filing IPOs to meet the demand. Returns are great -- almost double the S&P 500. One hundred fifty-seven IPOs have priced this year, up 29% from last year. You have to go back to 2001 or 2000 to beat that.

Investors are interested in IPOs. Bond market -- can't do that. Real estate -- not going to do that. What's left?