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Have I got a deal for you

The starter’s gun has been fired and we’re off. We’re getting an ever-increasing number of emails at Motley Fool HQ asking us about the initial public offerings that are fast hitting the local bourse. Everyone wants to know “is this the one to buy?”.

Warren Buffett once said: “If you’ve been playing poker for half an hour and you still don’t know who the patsy is, you’re the patsy”.

That quote is worth keeping in mind as our market starts to hot up. The phalanx of initial public offerings <completed> (http://www.fool.com.au/2013/08/02/steadfast-ipo-buoys-the-market/), underway, announced and mooted – and there are a heap of them – confirms both the mood among investors, and the feeling among the investment banks.

That feeling, put bluntly, is “the punters are prepared to take more risk – quick, get these things onto the market”.

Funding growth

There’s nothing untoward about the IPO process in general, or even the IPOs that have been and will be launched this year and into 2014. The share market is supposed to work that way – as a marketplace for those with money and those seeking it. IPOs are a tried and trusted way for supplying growing businesses with the injection of capital they need.

Of course, you should never get between an investment banker and a bucket of money, and a whole industry has sprung up to take advantage of the process.

Once upon a time, you had a great business that was serving consumer needs wonderfully, but was short of the funding it needed to expand. So you turned to the stock market as a way of reluctantly ceding a part of your business in exchange for the capital you need.

Sure, you now owned a smaller proportion of the company, but if the new capital was used profitably, the overall business grew so that your smaller proportion was worth more as the company grew.

That was then.

IPO – It’s Probably Overpriced?

The new version, in many cases, is less about providing much needed funding for growing businesses as it is an ‘exit plan’ for the owners and/or private equity firms. There are many examples of private equity firms buying cheaply, improving the business and/or stripping out significant costs, and refloating the business for a massive profit.

There’s nothing wrong with that situation, per se, but you need to know what you’re buying, who you’re buying from and how much you’re paying.

Let me put this another way – if you had a wonderful business that you owned outright, would you sell it? Probably only for a few reasons. Maybe you’ve wrung out as much growth as you can? Perhaps there are some cracks starting to show? Or you might find yourself able to sell it for top dollar – a price too good to refuse.

If you were a buyer, which one of these reasons would you prefer? If you’re like me, you’d choose ‘none of the above’.

Understand your opponent…

To be fair to the people behind these IPOs, we should take a similar view when it comes to buying and selling all shares. Any time you buy shares, someone is selling. That person has decided “I don’t think this company’s shares are worth holding”. The reverse also applies when you sell and someone else buys.

It’s a perspective that many investors ignore. They shouldn’t. There’s a lot of value to be gained by putting yourself in the other party’s shoes and asking “What do they see that I don’t?”.

In the case of IPOs, it’s an even more important question. Why would someone who owns the company, knows it inside out and has a great perspective on its future, want to sell? The answer may – or may not, of course – be as rhetorical as it sounds.

…and know thyself

There’s also a strange psychological process at play when it comes to IPOs. While Wesfarmers (ASX: WES) shares, for example, might be available between 10am and 4pm any day of the trading year, the ‘limited time’ effect works nicely for those selling IPOs.

The message – rarely stated but clearly observable – is “You’d better get in now”. Creating such urgency is gold when it comes to selling an IPO. People hate to miss out – hence the flood of emails we’re receiving.

Foolish takeaway

There’s a reason Warren Buffett gave us the quote about poker and patsies. He was warning us to be careful – to think about what we’re doing and who the other party is. There are likely some quality businesses among those which will IPO in 2013 and 2014. Of those, a much smaller proportion will be reasonably priced for potential buyers.

It’s important to ignore the rush and let (lower-case ‘f’) fools rush in where angels fear to tread.

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