Alibaba, Hong Kong and the US's Hot IPO Market

As this is being written Alibaba is in the middle of its roadshow to promote what is shaping up to be one of the world's largest ever IPOs. 2014 is turning into an investment banker's wet dream with IPO activity in the US expected to be the best since 2000 according to a recent report by Renaissance Capital.  

As most readers will remember the year 2000 was when the Nasdaq topped out at just above 5,000 before falling by almost 80% in the following 2.5 years.  The index is now close to that 5,000 level after 13 long years.

This recent history has stuck with me for a while.  As I wrote in a previous blog post my gut feeling is that a large number of IPOs tend to signal an expensive and overbought market.  

What is good for corporate capital raising and bankers is unlikely to be good for investors.

In that post I found that my hypothesis is not watertight, at least on a global scale. In several years an increase in IPO proceeds foreshadowed a good market the following year.  It seems that all the positive feedback from the hype surrounding IPOs as well as good post-IPO performance encouraged people to get into the market. 

What I did find was the opposite.  A widely-followed global index increased every year after capital raised via IPOs decreased.  In other words, investors were rewarded in the year after proceeds raised through IPOs decreased.


United States

Using similar data - this time from Renaissance Capital - it appears that there is a stronger relationship in the US between IPO capital raised and subsequent market performance. (Renaissance Capital's reports can be found here and here.)

As seen in the chart below, the S&P 500 index mostly moved in an opposite direction to the change in IPO proceeds in the previous year.  This happened in 10 out of the last 12 years as shown by the large number of red arrows.

When IPO proceeds increased in one year, the index was largely flat or declined in the following year.  And vice versa.  

The average rise in the S&P 500 index in the seven years after IPO proceeds decreased was 10.8%.  The average fall in the index in the five years after IPO proceeds increased was 0.5%. 

Readers should bear in mind that these are all rough numbers and based on a small sample. 

Hong Kong

Closer to home things get more interesting.  

In the last twelve years Hong Kong's IPO proceeds have given a much different signal. It appears that there is more of a momentum effect of IPO proceeds in Hong Kong.  High IPO proceeds in one year leads to a rising index in the subsequent year.  

In 6 out of the last 13 years the direction of the Hang Seng Index's rise or fall was the same the previous year’s change in IPO proceeds.  In other words, positive IPO issuance in one year tends to foreshadow an increase in the index the following year.

This was almost all during the go-go China boom years of the early and mid-2000s.  IPO proceeds increased some 14x from the 2001 low of HKD22b to the 2006 pre-GFC high of HKD332b.  

Since 2008 there has mostly been a negative correlation between the two.  (Again I need to emphasize the extremely low number of data points).

The average rise in the Hang Seng index in the 8 years after IPO proceeds decreased was just 2.3%.  The average rise in the index in the 5 years after IPO proceeds increased was 10.8%.

Hong Kong More Influenced by the US? 

But where it gets even more interesting is comparing the directional change in the main US and Hong Kong indices.  In almost every year since 2001 the direction of the Hang Seng index was the same as the S&P 500.   This is highlighted by the blue arrows between the last two columns in the chart below.  

From this quick and dirty analysis it appears that the US IPO market has been a better predictor of subsequent performance of the Hang Seng index than the local IPO market. 

This corresponds to my experience. When I was a sell-side equity analyst many of my portfolio manager clients in Hong Kong complained that they spent more time trying to figure out what the US market would do rather than analyze the situation in Hong Kong or China.  

Back to 'Baba

I do not know what direction the Hong Kong, US, or any other market will go next year.  It has been shown time-and-again that most predictions are useless.  In my opinion they are typically no better than one's astrology sign or Chinese zodiac.  

However with Alibaba's huge IPO, US equity indices reaching new highs and some believing that the US equity market is in bubble territory I'm feeling even more cautious than when I wrote the previous blog post last December (see John Hussman's market comment here).

But investors should bear in mind that I had the same feeling when Facebook went public in May 2012. Like Alibaba it was one of the largest IPOs ever. Upon listing it was the largest company to float with a market capitalisation of some USD100b.  It is now worth over USD200b, and is up slightly more 100% since its IPO price.  

Since Facebook's IPO, markets have also done well. The S&P500 and Nasdaq indices are up 41% and 50% respectively. The Hang Seng Index is up 19%. 

I was wrong about Facebook signaling a market top and lost out on considerable upside.  There are many reasons that I could be wrong again, but after this analysis I’m even more cautious on not just the US but Hong Kong as well. 

Decrease in IPOs is a Good Signal

Closing out the year, IPOs are back in the news.  There were several large IPOs in HK and the US in the last quarter of 2013 and many had good first day price increases.  Some press articles are expecting IPO activity to increase in 2014 with many calling for it to be the best year for IPOs since 2007 (articles here and here).  

A large number of IPOs always seemed like the sign of a market top to me.  But this has been more of an assumption than something based on fact or past performance.

Thanks to accounting firm Ernst and Young and index provider MSCI I was able to assemble the chart below.  It shows IPO capital raised and overall global equity performance as tracked by the MSCI All Country World Index (ACWI) for the past 11+ years.  Not a large sample at all, but better than nothing.

Bear in mind that these are quick and dirty numbers and not a strict apples-to-apples comparison.  Ernst and Young's IPO figures include several markets that are not included in the AWCI index such as Argentina, Columbia, Syria and Ukraine.  

However all of the large markets are included in both - the US, UK, Japan, China, etc. The US accounts for close to 50% of the MSCI ACWI and it has been the largest issuer of IPO equities in two of the last three years. “It is better to be roughly right than precisely wrong”, John Maynard Keynes is believed to have said.

The quick and dirty comparison shows that in the past eleven years, the global index increased every year after IPO raised capital decreased.  In other words, a good time to invest would have been the year after the amount of money that went into IPOs decreased.  This is highlighted by the red arrows in the chart below.  

However the reverse does not seem to hold.  In the six years that more money went into IPOs, the global index increased in four of those years and decreased in two.  

Thus my initial assumption was wrong.  A large increase in money raised by IPOs does not necessarily mean a market top.  If anything, I suspect that the amount of media attention surrounding new companies coming to the market likely generates more interest in the stock market which helps keep or push up prices and valuations.  

One additional observation.   For the last 12 years, there has mostly been a direct correlation between the direction of IPO capital raised and the direction of the index.  The only years the two were not in sync - at least during this time period - was 2003 and 2012.  In both years IPO funding decreased while the global market index increased.