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IPOs: watch out when investing in stock market newcomers

By Alexander Dominicus

Right now, there are a lot of companies going public, but this hype is also flooding the market with an abundance of companies of mixed quality. Alexander Dominicus, Portfolio Manager for the MainFirst Top European Ideas Fund and the MainFirst Germany Fund, explains what stock pickers should watch out for when it comes to identifying good business models.

IPOs can be good investment opportunities for market participants, as in most cases these companies will be introducing themselves to potential new investors for the first time during the course of the transaction. "These companies are still completely unknown at this point, their risk/return profiles often not sufficiently explored," explains Alexander Dominicus. "That is why it is important not to invest blindly in what are considered hype companies."

Topics such as technology, e-mobility and renewable energies, in particular, are in such high demand that poor business models are sometimes overlooked and valuations can climb from record to record. It is possible that companies operate unprofitably and with low margins, but still have a high valuation. "Valuations are often based only on sales multiples," says Dominicus. "Therefore, it is important to be cautious. It is questionable when investors in these cases will get their invested capital back in the form of cash flows and dividends."

Investors need to do their homework

Investors should take a closer look at IPOs: "It is important to look beyond a well-crafted marketing presentation," Dominicus explains. An indication of a rather mediocre business model could be, for example, if investment pitches focus primarily on megatrends and market potential. Dominicus clearly states: "Market potential only becomes interesting when the company can convincingly explain how it is able to convert the size of the market into sustainable returns. This includes solutions that cannot be provided by competitors or a customer benefit that offers added value compared to previous products. "Successful companies offer their customers superior solutions to problems, which are differentiated in terms of quality and price," says Dominicus. These are often niche players that have better business models and generate more returns for investors in the long term.

Good business models are decisive

Overall, it is crucial for investors to identify good business models, because companies with growth potential have also entered the market in recent months: "If companies operate in a market with high entry barriers, are highly profitable and growing strongly, it can make sense as an investor to accept higher valuation multiples.” According to Dominicus, such investments can then definitely offer potential for alpha. “In this phase, as an investor, you have the opportunity to find good companies before others discover them and, as a result, you can benefit when companies build up a good reputation on the stock market over time and capture growth potential." Dominicus also takes advantage of this effect in the funds he manages when opportunities arise. "We critically scrutinise the companies' assumptions and form our own unbiased and individual picture of the respective companies. This has always proven to be the best recipe for sustainable success in the long term. In this way, we have already been able to profit from many particularly successful IPOs in the past and will also try to take advantage of these types of risk/return profiles in the future."

Author: Alexander Dominicus, Portfolio Manager of MainFirst Germany Fund & MainFirst Top European Ideas Fund

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