Investing in the Next Generation of Market Leaders
Steve Norwitz - March 31, 2013
Every investor’s dream is to get in on the ground floor of the next Apple or Google well before such companies become huge success stories and their stocks soar in value.
While the rewards can be great, the odds of success are usually low. “IPOs [initial public offerings] are a very risky segment of the market,” says Brian Berghuis, manager of the Mid-Cap Growth Fund. “For every success there are dozens of companies that meander through their corporate lives or outright fail. So it’s important to ferret out the rare company that may have at least the potential for major success.”
A recent T. Rowe Price study shows how difficult that can be. It tracked some 4,500 companies that went public from 1995 through 2007 and measured their progress through the end of last year.
Of those with less than $100 million in revenue at the time of their IPO, representing about three-quarters of the total, about 40% had reached $100 million through last year, and only one in 20 had reached $1 billion in revenue, marking a major milestone.
Of the roughly two-thirds of more seasoned companies that went public with more than $100 million in revenue over this period, only a third had reached the $1 billion mark in revenues through 2012. (The study did not account for companies that were bought out sometime after the IPO.)
And while many investors might expect to find these diamonds in the rough in such high-profile industries as technology and health care, some of the best success rates were found in relatively less dynamic sectors, such as energy, industrials, and consumer.
Based on his own analysis of IPOs over the past decade or so, Henry Ellenbogen, manager of the small-cap New Horizons Fund, says: “Only a few outliers actually get to $1 billion of sales. Just 3% have what it takes to become large-cap companies, and about half of them become road kill.”
T. Rowe Price invests mainly in companies with established track records, but the firm has participated in the IPO market for decades and is one of the largest investors in that arena. Equity analysts examine virtually every IPO that comes down the pike—many even before the IPO while the companies were still private.
On average, the firm participated in about 40% of all IPO issues over the past four years. In fact, about 25% of all U.S.-listed stocks that T. Rowe Price owned as of December 31, 2012 (excluding those in index funds) were originally invested in as IPOs over the past 20 years, although some were not owned continuously since the company went public.
Even picking “winners” that soar in early trading, however, has negligible impact on fund performance initially because of the relatively small position a fund may take in the stock. But, over time, as managers’ confidence and investment in these unproven companies increase, some have become significant contributors to shareholder returns.
Indeed, the firm typically views IPO investments as potential long-term holdings rather than an opportunity to turn a quick profit by “flipping” these stocks. Several dating back to the 1990s remain in portfolios today.
“IPOs are a very important part of the investment process here,” says Preston Athey, manager of the Small-Cap Value Fund. “First of all, you don’t want to miss the next potential big winner. Also, you learn about possible threats to your other companies.”
Hugh Evans, an IPO specialist and equity analyst for the firm who has examined more than 1,000 IPOs over the past 18 years, adds: “It’s crucial to focus on the next generation of potential breakout companies. Over time they could potentially account for such a large portion of a portfolio’s return.”
For example, Mr. Evans cites another T. Rowe Price study showing how relatively few stocks can drive performance over time. From 1985 through 2012, the Russell 2000 Index of small-cap stocks had an annualized return of 12.6%. If the top 10% of performers in the index were excluded, the return would have been just 2.6%.
Another key reason the firm spends a lot of time studying new companies is to gain insight into possible threats to existing holdings.
“When you have a new company with a potentially disruptive business model, you’d better be familiar with it if you own one of their competitors,” says Dan Martino, manager of the Media & Telecommunications Fund.
Tom Watson, a computer software analyst, adds: “That perspective is especially important in software where the rate of change now is the highest it’s been since we switched from mainframes to client servers in the 1980s.”
Keys to Success
While the criteria for evaluating newer companies can vary from one industry to another, there are certain characteristics managers consider crucial. Having a solid business model and an innovative product or service with expansive market potential is important, but the quality of the firm’s management comes above all else.
“Most of these small companies will live and breathe to the rhythm of an entrepreneur with a vision,” Mr. Evans says.
Jack Laporte, former manager of the New Horizons Fund for 23 years, adds: “I’ve seen good managements make mediocre businesses very good stocks and bad managements turn good businesses into disasters.”
Mr. Ellenbogen says he focuses on two key attributes in evaluating smaller companies. “One is a fundamentally better business model and the company continues to innovate,” he says. “The second is: Do they have an Act II that goes beyond the initial business model.”
T. Rowe Price managers have uncovered many interesting opportunities to invest in newer companies throughout the economy, including some that have already evolved into industry leaders and others that are forging new breakthroughs.
Here is a glimpse of a handful of IPOs the firm has participated in over the years and more recently in various sectors.
One of the firm’s longest-held companies bought on its IPO is Whole Foods Market, the natural food supermarket chain that went public in 1992. As a young analyst then, Mr. Berghuis believed in the company’s future even though Wall Street viewed it “as a really narrow niche, almost a fringe, hippie concept,” he says.
In a memo to the firm that year, Mr. Berghuis wrote: “I do not view natural foods retailing as a fad. It appeals to the baby boomers’ interest in health and wellness. As consumer concern about nutrition grows, several natural foods retailers, including Whole Foods, are moving into the cultural mainstream.”
In addition to the company’s potential market growth, Mr. Berghuis was intrigued with its chief executive, John Mackey.
“John Mackey ranks up there with the top CEOs I’ve ever known in terms of thought leadership, innovation, openness to new ideas, and his ability to manage people and create a culture that was highly differentiated,” Mr. Berghuis says. “So we had a company led by a passionate entrepreneur with a truly unique outlook and strategy. Whole Foods represented a huge innovation in what had been a fairly stodgy supermarket industry.” Today, T. Rowe Price remains among the company’s largest shareholders.
Other consumer-oriented companies that found new ways to innovate that the firm has participated in from the start include longtime holdings Panera Bread and Starbucks and such recent investments as Angie’s List; OpenTable, the leading electronic restaurant reservation platform; Allegiant Travel, a discount airline focusing on smaller, less competitive markets; and Youku.com, the leading online video site in China.
The firm invested in Facebook even before it went public. That has not been as rewarding as expected, but the firm’s due diligence on that company bolstered its confidence to invest in LinkedIn, a professional social networking company, when it went public two years ago. In contrast to Facebook, LinkedIn has exceeded expectations.
“People felt Facebook would create significant pressure on LinkedIn’s business model,” Mr. Martino says. “Our work on Facebook made us realize that this was not the case.
“LinkedIn is more of a business services model. Most of its revenue comes from recruiting services for HR [human resource] professionals. They are really disrupting the traditional HR recruiting model. This company has basically invented a new industry.”
As part of its research, T. Rowe Price convened a panel of HR professionals from various companies familiar with LinkedIn’s services. “It was clear from that discussion,” Mr. Martino says, “that they thought this service was incredibly good and that it enabled them to do something they couldn’t do before—hire the most attractive candidates more efficiently, including those who were only passively looking for jobs.”
The software industry has been a fertile area for IPOs recently. Mr. Watson says 18 of the 34 companies he now covers were invested in at the IPO stage in recent years.
Although most have done well, “I know that not all 18 of our current software IPOs will make it to mid-cap or large-cap land, but if one or two do that’s a big success,” he says.
One of Mr. Watson’s five “sources of durability” for software companies is, simply, to “do something that’s really hard.” Among the more promising companies in this category is Workday, which has become the HR software system of record for businesses, helping manage employee profiles and performance and benefit programs.
“What Workday does requires so much complexity that it creates a barrier to entry that we think will improve its chances of becoming a larger business over time,” Mr. Watson says.
Other newer software companies that meet Mr. Watson’s criteria for durability include Concur Technologies, which serves the credit card industry and travel ecosystem; Sourcefire, a security software firm with a strong distribution network; Cornerstone OnDemand, providing employee performance and management learning services; and two companies that dominate small markets: RealPage, specializing in commercial real estate software, and Guidewire Software, which replaces old back-end systems for the insurance industry.
In this fast-changing industry, Mr. Watson says the most successful IPOs generally “have been those with some sustainable advantage besides the pure technology itself. Sometimes you find a software company that is gaining market share because it can perform a process slightly faster than the last generation. I’m more cautious on those because if there is no differentiation, in a few years there will be an even faster alternative.
This industry has generally been a minefield for IPOs in recent years, but the firm has invested in some new companies with unique products or services that are doing well. One is Pacira, which went public in 2011.
This company produces a long-lasting anesthetic that can provide post-surgery relief for up to 72 hours compared with six hours for existing drugs. This helps reduce recovery days in the hospital and provides an alternative to such powerful medications like morphine, which is often used for postoperative care and can have damaging side effects.
Athenahealth and Pharmasset are two other stocks the firm invested in on their public offering six years ago. Athenahealth provides information technology services for physicians that help reduce administrative overhead and increase efficiency. Pharmasset developed a hepatitis C medication and was subsequently acquired by Gilead Sciences, adding a significant new growth opportunity for that company.
The revolution in hydraulic fracturing and horizontal drilling is creating a boom in shale oil and gas production and new opportunities for both established leaders and newcomers with attractive assets.
“Not many people realize that the U.S. is now the third-largest producer of oil and natural gas liquids in the world,” says Shawn Driscoll, an energy analyst. “In terms of just oil, we’ll pass Saudi Arabia within two years, and a year or two after that we’ll pass Russia to be the largest. So we own a lot of companies levered to this.”
One is Oasis Petroleum, a shale oil producer that went public two years ago. “Oasis is a classic situation of how we get interested in IPOs,” Mr. Driscoll says. “We had spent a lot of time in the Bakken field and we knew the economics of their wells, which is what drives these companies. So when the IPO was announced, we already knew the company and its assets very well.”
In searching for such potential investments, Mr. Driscoll says: “We spend most of our time on the oil and gas basins themselves, sifting through well information to figure out who has the best rock. And then we focus on the people because you can have very smart people, but if they don’t have good geology it won’t be a good stock.
“You just can’t make bad rock look good, but there are plenty of people who have made good rock look bad. That’s why we try to focus on both, and even then we’re probably only successful about half the time.”
T. Rowe Price initially invested in Google on the public offering in 2004, recognizing its substantial growth potential in U.S.- and international-sponsored Internet search. It currently represents the firm’s largest holding, accounting for $7.5 billion in assets alone. The bulk of this position, of course, was acquired in subsequent years after the IPO.
T. Rowe Price remains enthusiastic about Google’s future prospects. “Over time they have proven to be very innovative and ambitious,” says Paul Greene, an analyst who now follows the company.“They do not rest on their laurels. They are always pushing the needle.They are the leader in so many of tomorrow’s technologies and are well positioned in major growth areas. Their management team and willingness to think long term, aside from having a strong core business, leads us to believe that they will have continued success.”
What Can Go Wrong
By being very selective and cautious, taking a long-term approach, and always doing its homework, T. Rowe Price overall has had its share of success in IPO investing. But for various reasons, not all of these companies fulfill their promise.
“Sometimes our judgment is faulty, sometimes the concept is worthwhile but the execution is faulty, and sometimes it’s just bad timing,” Mr. Berghuis says. “A lot of factors can intervene between the best laid plans and success.”
In that regard, the jury may still be out on Groupon, but it represents one of the firm’s biggest disappointments and misjudgments to date. T. Rowe Price invested in the Internet-based commerce company even before it went public in late 2011. It was one of the hottest tech IPOs, valued at $16.5 billion. Since then the company’s stock has plummeted, its chief executive fired, and its market value fallen below $3 billion.
“When investing in companies with grand visions within entirely new industries and strong early success, it is inevitable that we will sometimes be wrong, as we were with Groupon,” Mr. Martino candidly wrote in a recent report to shareholders.
He adds: “The management execution certainly hasn’t been good, but the market opportunity probably was not as big as we thought. The product proved more faddish and trendy than a mainstream marketing channel….Consumers kind of got fatigued with it.”
Despite such inevitable setbacks, and a substantial decline in the number of IPO opportunities since the financial crisis, T. Rowe Price remains committed to this strategy.
“It may be more challenging,” Mr. Berghuis says, “and we may have more misses than big successes, but it absolutely remains an important part of our investment process. New companies are the lifeblood of public markets, so we have to stay focused on them.”
As of March 31, 2013, the stocks mentioned in this story and charts accounted for 4.2% of assets of the Mid-Cap Growth Fund, 22.2% of the Media & Telecommunications Fund, 1.1% of the Small-Cap Value Fund, and 10.0% of the New Horizons Fund. Please note that the funds did not acquire their entire ownership of these securities at the time of the IPO. As of March 31, 2013, none of these funds owned Groupon or Pharmasset. For a complete list of portfolio holdings for all of the T. Rowe Price funds, go to www.troweprice.com.
Past performance cannot guarantee future results. All charts are shown for illustrative purposes only and do not represent the performance of any specific security.