The initial-public-offering market appears to be a victim of its own success. An excess supply of stocks, combined with the market's recent sluggish performance, has hurt potentially lucrative IPOs, making them tougher sells.
The pain caused by dramatic market dips and a slowdown in the IPO market is not confined to individual investors. Traders on both the sellside and the buyside know of the agony.
"It makes our life more demanding," admitted Raymond Murray, director of trading at Minneapolis-based Investment Advisors.
For one thing, uncertain expectations can cause portfolio managers to suddenly drop out of a pending IPO, and leave traders feeling a little flabbergasted. (Conversely, less competition over IPOs can enhance some institutional firm's allocation prospects.)
For another thing, some traders said that money flowing into mutual funds is not keeping pace with the flood of new issues, thus hurting the trading performance of seasoned stocks competiting for a proportionately smaller pool of capital.
Moreover, the tremendous supply of new offerings hitting the market over the past three years has partly contributed to the relative underperformance of small-cap stocks, market sources noted.
"There's enough pain for investors, and they're not really interested in adding new stocks to their portfolios," said Tom Dudenhoefer, head of Nasdaq trading at Raymond James & Associates in St. Petersburg. "The general response we're hearing is, I don't need to add a new name in that industry when I already have four other companies in the same sector that are underperforming.'"
"There's been a real liquidity crunch in the stock market in general," added Bruce Lupatkin, director of research at Hambrecht & Quist in San Francisco. "The supply of large-cap names doesn't grow nearly as fast as the supply of small-cap names."
Institutions
Institutional clients, comprising the bulk of an offering's book and the majority of first-day trading activity, have largely vacated the IPO market to concentrate on their existing holdings, according to trading officials.
"IPOs are an interesting anomally to the overall market," Murray said. "With an IPO, you have the chance to safely land on the beach when you want. Lately, underwriters have been saying to themselves, I'd like to land on the beach when their is a little less gunfire.'"
In the midst of a plummeting Dow Jones Industrial Average, just 16 issuers were able to bring deals to market in August. In contrast, underwriters were able to place a total of 47 IPOs in July.
With the pace of IPO issuance slowing and many underwriters forced to severely discount deals due to market conditions, first-day trading volumes have soared on many recent deals.
"IPOs generally price at about a 20-percent discount to publicly-traded comparables," noted the head of one over-the-counter trading desk, who requested anonymity. "Ideally, an underwriter would like to see very little volume in the initial day of trading."
With the market's recent volatility, however, such discounting has become accelerated, leading to higher-than-normal first-day trading activity, traders said.
Oversupply
Since the beginning of 1997 through the end of the second quarter 1998, there were 2,082 IPOs and secondary offerings, tapping investors for $298.3 billion, according to Securities Data Co. Over the same period, investors poured $372.9 billion in fresh capital into mutual funds, according to Washington-based Investment Company Institute.
During the second quarter, however, new-equities issuance totaled $71.1 billion, outstripping net sales into mutual funds by $2.28 billion.
"Liquidity is certainly a problem," said the head of a major New York trading desk, who declined to elaborate for fear of antagonizing his firm's syndicate department.
Although IPO issuance could once again reach historic heights in 1998 trailing perhaps only 1996, when 872 issuers raised $49.89 billion a growing list of companies are seeking shelter from increasingly hostile public markets. They are either withdrawing proposed IPOs or opting toward the inviting arms of private equity groups or willing acquirers.
"There is no question that the IPO market has cooled dramatically since the red-hot peak of 1996," said Paul Deninger, chairman and chief executive of Broadview, a New York-based mergers-and-acquisition investment bank.
Because fund managers have consistently underperformed the broader market indices over the past few years, most have shied away from more volatile IPOs, said Claudia Mott, who tracks the small-cap and mid-cap markets for New York-based Prudential Securities.
During difficult market conditions, the ability of investment banks to underwrite potential new offerings becomes further exasperated as individual investors pull money out of smaller mutual funds.
"It's like putting lighter fluid on a gas grill," noted Mott, alluding to the need of fund managers to liquidate holdings to meet the investor redemptions.
Over the four-week period ending Aug. 5, 1998, investors pulled a total of $662.4 million out of small-cap growth funds, according to AMG Data Services in Arcadia, Calif.
Small-Cap Earnings
Some of the market's hostility toward small-cap stocks is attributed to recent earnings performances, which have only begun to feel the pinch of the Asian financial crisis, market observers noted.
"Since the beginning of the year, there has been selected underperformance within the small-cap area," Lupatkin said. "In June, earnings performances for companies in our universe weren't improving, they were decelerating."
Year-over-year, second-quarter earnings for small-cap companies climbed about 2.2 percent, compared to a 2.8-percent increase for Standard & Poor's 500 companies, according to Chuck Hill, director of research at First Call in Boston.
While second-quarter earnings growth between small-cap and large-cap companies appears to be comparable, the disparity is highlighted by their respective sequential growth. According to Hill, first quarter, small-cap earnings climbed 8.1 percent, versus 3.8 percent for S&P 500 companies.
Tough Sell
The net result of all the new supply and the slumping earnings performances: Investors are balking at many new offerings. During the month of August alone, about 20 potential deals were postponed due to "market conditions."
Some portfolios managers, however, are quick to point out that when IPO issuance has stumbled in the past, such discounting has created a healthier environment for long-term capital appreciation.
"Our philosophy is about trying to remain in stock selection," said Kathleen Smith, a manager of the IPO Plus Aftermarket Fund, a mutual fund that invests in recently-issued stocks. "We believe that there are still some attractive opportunities our there."
Unlike other funds, the IPO Plus Aftermarket Fund has remained an active purchaser of new offerings, keeping just ten percent of its assets in cash.
Investment Advisors' Murray added that his firm is still active in the IPO market, and that his portfolio managers are assessing each issue on an individual basis.
Stephen Lacey is associate editor of The IPO Reporter, a sister publication of Traders Magazine.
New Issues Squeeze Capital Supply
(Yearly Quarters)
1997
Q1 Q2 Q3 Q4
IPOs and Secondary Offerings $29,147.3 $40,907.7 $40,401.5 $82,846.4 $33,848.9 $71,111.6
Net Mututal-Fund Sales $59,559.8 $53,081.7 $63,547.7 $64,101.9 $63,746.1 $68,832.5
Source: Securities Data Publishing. Note: Dollar figures are in millions.
cont'd
1998
Q1 Q2
$33,848.9 $71,111.6
$63,746.1 $68,832.5
Source: Securities Data Publishing. Note: Dollar figures are in millions.
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