A high percentage of newly listed companies end up with earnings that are quite different from forecasts announced at the IPO and the forecast for the first year after the IPO. Moreover, when these companies cut their forecasts, their stocks instantly become overvalued. Many investors have suffered large losses due to the subsequent drop in the prices of these stocks.
Why are these companies forced to slash their forecasts by so much? I think one reason is the immense pressure on companies to grow once they are listed on a small company stock market. In fact, growth potential appears to be one condition for the approval of IPO and exchange listing applications by securities companies and stock exchanges. Furthermore, the executives of these small companies believe that earnings growth is a key component of their stock prices.
But enactment of the Financial Instruments and Exchange Law makes internal controls and timely disclosure more important than growth. This forces small companies planning on an IPO to focus their time and resources on fulfilling these legal requirements rather than on growth. In effect, this is putting the cart before the horse.
Upgrading internal controls and announcing quarterly operating results add tens of millions of yen to the annual expenses of companies listed on small company stock exchanges. At the IPO, small companies often have annual ordinary income of about ¥100 million to ¥200 million. Internal controls and disclosure alone can bring earnings down by 20% to 30%. Even if a company can increase its operating income, growth in these other expenses may cause bottom-line earnings to fall despite rising sales. As a result, revisions to requirements for publicly owned companies are creating difficulties at many small companies that conducted IPOs since 2000 .
The stock prices of IPO stocks have been extremely weak amid lackluster trading value on Japan’s three small company stock markets. There were 121 IPOs in 2007, and 120 of these companies were still listed at the end of July. For the 120 companies, opening prices were an average of 49.6% higher than their offering prices. But at the end of July, market prices were an average of 30.6% below the offering prices. Furthermore, stock prices are now less than half the opening prices for the majority of the 120 companies. Only 17 of the 2007 IPO stocks are trading at a price higher than the offering prices.
Stocks of companies that went public in 2008 are performing better. For the 25 companies that conducted a 2008 IPO, the average opening price premium over the offering price was 35.1%. At the end of July, the 25 stocks were an average of 21.6% above the offering prices but only slightly higher than the opening prices. Even so, returns on the 2008 IPO stocks are higher than for the 2007 IPOs.
There have already been three IPOs in August, and all three stocks are currently trading below the offering prices. The cause of this weakness is not a worsening in the supply-demand balance due to scheduling three IPOs within such a short time. Overall weakness of stock markets was responsible for holding down the valuations of these stocks.
Fewer than 10 IPOs are planned for each remaining month of 2008. It is unlikely that an oversupply will cause the prices of these stocks to drop. But small company stock markets are unlikely to attract significant inflows of new capital. That means we will probably continue to see a shortage of buyers.
However, some upcoming IPOs will probably be excellent opportunities for long-term investors to purchase stocks at very attractive valuations.
