How to spot dangers when considering an IPO investment

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Initial public offerings (IPOs) can be extremely seductive to investors. With the Australian market largely stable, a new, exciting and innovative stock can seem like a breath of fresh air after months of reading about the same old banks and miners.

By looking at some of the IPOs that have failed over the past few years in this article, you can train yourself to be wary when the same features are evident in future stocks.

So what are some of the worst performers, and what went wrong with them?

The most notorious and high profile dud of recent years was the catastrophic failure of Dick Smith Holdings Ltd (ASX: DSH). There were some major factors that contributed to the retailer’s decline. The first was elevated inventory levels that could not be cleared. This stemmed largely from the decision of the retailer to maintain a high level of private label goods. Evidently, consumers did not warm to these “no brand” accessories and products.

Poor ranging decisions also contributed to excess stock levels. Excess stock shows that cash is not being paid by customers, and that the products are not in demand. At the same time, suppliers, staff and rent must be paid. In this scenario, cash dwindles quickly.

Lesson: retail is easier to assess than most sectors. Before buying shares in a retail stock, go into a store and walk around. Would you buy anything? Is the store full? Is there heavy discounting in an attempt to move products? Half an hour in a store will give you just as much insight as any article you could read.

Spotless Group Holdings Ltd (ASX: SPO) is another private equity float that has disappointed. Initially, investors were drawn to the defensive nature of the company – no matter the state of the economy, hospitals, offices and mining camps would still have to be cleaned and maintained.

However it is now clear that Spotless is competing in a competitive market with limited ability to raise its prices. It is also beholden to rising wage costs, penalty rates, as well as the costs that come with tendering for new contracts.

Lesson: make sure you look at the costs and the competitive environment of a company. Spotless faces heavy competition on price, so is vulnerable to competitors undercutting it. As a result, it also cannot raise its prices to cover rising wage costs. That results in falling profits, even if the company can hold revenue steady.

Reffind Ltd (ASX: RFN) is one of the many small cap tech stocks to IPO recently. After debuting at $0.26, it rose as high as $1.93. It is now a portfolio smashing 92% lower than those levels, at $0.15.

Reffind provides companies with software that make it easier and simpler for businesses to interact, survey and train their staff. It came to market with an impressive list of clients, and regularly added blue chip leaders in the building and construction, legal and hospitality industries in the following months.

A lot of cash was spent by management travelling internationally to try and grow the business rapidly. However, the company could not add clients and earn money fast enough to cover the cash it was burning through. That led to a capital raising, which was followed soon after with downgraded forecasts.

Lesson: with tech companies, cash in the bank is crucial. If a company is spending money too fast it will almost certainly return to the market for more cash. That will lower the value of the stakes of existing holders.

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Motley Fool contributor Ry Padarath has no position in any stocks mentioned. The Motley Fool Australia owns shares of Retail Food Group Limited. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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