Should you leverage to buy into IPOs?
By STEWART MILLER
Guardian Business Reporter
With over$100 million in initial public offerings(IPOs)expected to come on stream this year, you may be wondering if it is worth borrowing money to get in on the ground floor.
Guardian Businessasked some financial experts what prospective buyers thinking about using leverage to get in on the action should contemplate. The take-away message may be that while borrowing to buy into equities is not necessarily a bad idea, investors need to
do their homework and be confident about the security they will invest in.
“Leverage to make an investment or to buy shares is not a bad thing,”Ken Kerr, CEO of Providence Advisors said yesterday.”The critical point is the carrying cost of investments when you use leverage or borrow money.”
Basically it means that a prospective investor needs to look at how much he pays to borrow and compare it to what he expects to get from the investment. For example, if it is going to cost 9 percent to borrow for an investment which pays a dividend of 5 percent, but is not itself expected to increase in value, then there is a negative carrying cost of 4 percent.
Investors in equities such as common shares often expect or hope for the value of the investment to increase over time. Projections of the future value of those shares must factor into the carrying cost too. In the example above, if an investor expected the shares to increase in value by 5 percent, the carrying cost becomes a positive 1 percent and the investment looks like a better alternative.
But figuring out carrying costs may be the easy part–once an investor has a clear understanding of the future prospects and risks involved with security.
There are no guarantees with equities–if a company fails the shares are often worthless–but less dramatic conditions may also throw a monkey wrench into the budding investor’s plans. Liquidity, or more accurately a lack of liquidity is a real concern for shares traded on the Bahamas International Securities Exchange(BISX)and over-the-counter.
“The state of the market is such that there is very little liquidity. Shares don’t trade with frequency,”Kerr said. In an illiquid market, a small investor in urgent need of funds may sell at a low price and push the share price down. Kerr said many local banks in the past have been burned when lending with only securities as collateral because of the market conditions. As low trades depressed share prices, those banks would see their collateral devalue and eventually become insufficient to support the share collateralized loans.
For investors who chose to open a margin account with a local brokerage, depressed share prices often necessitated margin-calls–investors would have to pony-up additional funds to balance their accounts as share prices fell.
Jamaal Stubbs, senior research analyst with CFAL, toldGuardian Businessyesterday that liquidity and subsequent pricing issues have created opportunities for some currently traded equities, where depressed prices may be creating some true opportunities. His message on borrowing to buy into equities, whether by IPO or currently on BISX was similar though.
“Make sure you only borrow what you can afford to lose, don’t go mortgaging the house,”Stubbs said. He added that while every investor’s financial requirements were different, generally the amount borrowed for such a purchase should not take more than a year to pay back.
In addition to considering demand and liquidity, the homework really starts when investors look at some of the variables which will impact what the share price may be in the future.
Kerr mentioned several considerations. The prudent investor will analyse the formal prospectus, or offering document; be certain the securities are registered with the Securities Commission; consider the proposed company’s market environment and competition; look at issues in the industry; consider regulatory and taxation issues that may impact profitability and earnings; analyse financial statements and the dividend policy; and analyse the company’s management, for example.
“All these things go into the mix when you make a decision to make the investment,” Kerr said.”The critical variable is that the underlying investment is sound.”