The new-issue market is hot; some see danger, some don't
The Liberty bash is behind us. Lower Manhattan is once again the staid domain of Wall Street pin-stripers. Or is it? A party of a different sort is just hitting its stride: the wild part in newly minted stocks. The Standard & Poor's new-issues index -- which tracks major initial public offerings for their first 90 days -- is up an astonishing 56 percent in the first half of 1986. During the same period, the S&P 500 chalked up a respectable 18.7 percent gain for the half. And the Dow Jones 30 industrials scored a 22.4 percent gain.
Of course, not every new issue is a winner. The averages are skewed a bit by phenomenal gains in the biotechnology stocks and the likes of Home Shopping Network, a cable TV auctioneer that rocketed 350 percent in one month. Nonetheless, some revelers are saying it's nearly time to make a gracious exit from this soiree.
``It's looking pretty overheated at this point,'' says Robert Natale, editor of S&P's Emerging and Special Situations report. ``I'd be cautionary. Many of the new issues are coming out overpriced.''
``The party's on for the underwriters, but it's almost over in terms of good deals for investors,'' concurs Glenn Cutler, editor of the Red Herring, a newsletter published out of Pacifica, Calif.
An audacious new-issue market is considered one of the signs a bull market is peaking. Yet Mr. Cutler, who also issues the highly rated Market Mania timing letter, gives the bull about two more months. Indeed, last week expectations of lower interest rates pushed the Dow Jones industrial average above the 1,900 mark for the first time. By the final bell on Thursday (the markets were closed July 4), the Dow was at 1900.87 up 15.61 points in four trading days.
Soon though, says Cutler, ``We're going to get a good, good correction. There's going to come a time when new issues are at insane prices. It's getting to that point.''
He points to last week's debut of L. A. Gear as a sign of the times. That's a solid little athletic shoe company with revenues of $10.6 million in 1985 and $8.5 million in the first quarter of this year. Many analysts are likening L. A. Gear to Reebok, an athletic shoemaker that went public less than a year ago and now sells at a dazzling five times its offering price.
L. A. Gear was slated to sell at $8 to $9. At that price, Cutler (and other new-issue analysts) recommended its purchase. Instead, he says, it was sold primarily to institutional buyers at $11.50 and opened in the secondary market at $21. At that price, Cutler says, he's no longer interested. He points out that few if any individuals had an opportunity to buy the stock until it had doubled.
``The best deals are a function of a lack of interest. When you get a lot of buyers, near the top of a market, [the underwriters] start bumping up the prices at the last minute.
``I'd be real careful now,'' Cutler warns. But he's not throwing in the towel just yet. The high volume means there are plenty of new offerings to choose from, and the quality of the companies has not deteriorated substantially.
Norman G. Fosback, editor of the New Issues newsletter based in Fort Lauderdale, Fla., adopts an even more optimistic tone. He allows that ``it's been one heck of a quarter.'' The money raised through initial public offerings hit a record $5.8 billion in the second quarter. The previous record of $3.9 billion was reached in the heady third quarter of '83.
But Mr. Fosback notes some differences between this new-issue boom and the last. At the peak in '83, some 95 issues a month were coming out. Last quarter, the average was 60. But more significantly, most issues today are still fairly priced, he says.
``In 1983, it was not unusual to see technology companies sold at 50, 60, 100 times earnings. And at the time the overall market was much lower. The average P/E was 10-12,'' says Fosback. Today, he says the average price/earnings ratio is about 17, while new issues are running in the 20-to-30 range.
``I interpret this to mean the market is going to continue to realize very substantial growth in the months to come and don't think it portends an imminent market top,'' Fosback says. ``I think the [new issues] market will be strong through the end of the year.''
At present he's studying the preliminary prospectus for Aaron Spelling Productions (TV), Gartner Group (computer research and consulting), Genmar Industries (boat manufacturer), Tipon Centers (retail electronics chain), and Cellular Inc. (mobile phones).
How does he decide what to recommend to subscribers?
First, to thin the pack quickly and reduce risk, Fosback discards start-up companies -- those with little or no record of earnings.
Next, he says, ``The bottom line with any stock is growth vs. the P/E multiple.'' A common rule of thumb is that the price/earnings ratio (stock price divided by a company's annual earnings per share) shouldn't be more than half the annual growth of earnings expected. ``If you expect the company to grow at a rate of 50 to 75 percent, then a P/E of 30 is reasonable.''
He also digs into the prospectus to find out what the company plans to do with the cash raised. ``I prefer that they put it into new plant and equipment than pay off debt.'' And ideally, the current management shouldn't be selling out or pocketing large portions of the proceeds.
Fosback will also check to see if the company has been backed by a reputable venture-capital firm at any point. ``They may be a source of good advice.'' In fact, a study of initial public offerings over the last decade, published in the July 14 issue of Forbes magazine, shows that the price of a new issue was 2.5 times as likely to rise if it was backed by a venture-capital firm.
The study also notes the difficulty of picking winners. Only 4 out of every 10 new issues introduced since 1975 were above their offering price at the close of '85.
Another factor in choosing new issues can be the underwriter's record. The stocks sponsored by Advest, a Hartford, Conn., brokerage, have the best overall record for 1986, says Mr. Natale at Standard & Poor's. ``Four were in the top 20 performers, and there was only one loser in the bottom 20.''
Advest's corporate finance chief, Bart Ferris, says many deals are rejected if they seem overpriced. Advest had the third best record among underwriters over the last five years, according to Money magazine.