How to pick IPOs? Three techniques you need to know

Picking the right stocks is critical for investors. The same is true of HK IPO subscriptions. If you get it right, you are likely to make decent money. Otherwise, you will suffer losses. In this course, we'll discuss how to pick HK IPO stocks from three perspectives: company fundamentals, valuation, and market sentiment.

1. How to choose stocks using fundamentals?

Let's first look at the most important strategy: how to choose stocks based on companies' fundamentals. Promising IPOs are usually characterized by rapidly growing leaders with distinctive businesses in high-growth industries. We can break down the characteristics into four dimensions.

Firstly, the company is in a high-growth industry featuring huge growth potential, a relatively low industry penetration rate, and rapid growth prospects.

Secondly, the company is an industry leader. A firm that can outperform its peers in a sunrise industry generally has large competitive advantages, making it a potential disrupter. Hopefully, it can grab a great market share to lead by a wide margin.

Thirdly, the company grows at a rapid speed. As an industry leader, the company is supposed to grow faster than the average; otherwise, it is considered a fake leader with limited potential.

Fourthly, the company's business is distinctive. This creates high barriers to entry. At the same time, a lack of competition leads to strong profitability and a high gross margin.

From a quantitative point of view, companies that meet the following criteria might be considered promising. Of course, you can set your own standards for picking IPOs.

1. Growth rate of the sector exceeds 20% year on year

2. The company is an industry leader with a market share of more than 20%

3. The company's earnings grow at over 25% year on year

4. The company's gross margin surpasses 40%

For example, Angelalign Technology (code: 06699), listed in 2021, is a leading manufacturer of invisible orthodontic without bracket aligners in China. It has grown by more than 25% with a 70% gross margin over the past two years, with an industry-wide expansion of more than 40%. Angelalign Technology perfectly met our standards of promising companies, and its share price rose by 131% on the IPO day, with one-lot earnings hitting HK$46,000, making it the most profitable new stock in the history of HK IPO subscriptions.

It must be noted that the quantitative strategies listed above are not used as investment references. IPOs selected in this way also have the risk of falling below the issue price. We need to combine the valuation of IPOs and market sentiment to make a comprehensive selection.  

Angelalign Technology we mentioned is just an example, not as investment advice. There are also negative cases here. The SaaS leader in supply chain finance, LINKLOGIS-W(code:09959), is also in line with the strategies listed above. It went public in April 2021, and its share price has fallen by nearly 60% from its issue price.

2. How to choose stocks based on valuation metrics?

Next, let's take another perspective: How to value stocks to find a good pick. There are three important valuation metrics.

The first is the PE ratio, which measures a stock's market cap relative to its net income. This approach is fit for companies with stable profits. 

The second is the PS ratio, showing a company's market cap divided by its sales. This metric is generally used to evaluate growing companies that do not have stable profits for the time being. 

The third is the PB ratio, calculated by dividing a company's market cap by its book value. This measure is helpful in assessing heavy-asset companies. However, few promising IPOs are asset-heavy, so we do not use this method much.

For IPOs with good fundamentals, we can compare their valuation metrics with those of other companies in the same industry or of the same type. Generally speaking, these metrics of good IPOs will be higher than the average. But if it is much higher, say 30%, the underlying company may be overvalued. Conversely, it is considered fairly valued or undervalued.

3. How to measure market sentiment?

Finally, let's turn our eyes to market sentiment. We can interpret it in two dimensions.

The first dimension is the trend of the Hong Kong stock market. If the market is overall bullish, IPO performance is expected to be stronger.

The second dimension is the performance of recent IPOs. There are cycles in the IPO market. If the newly listed stocks perform well, then the market is more bullish on IPO Subscriptions, and the subsequent ones will perform better. Conversely, if the recent market is bearish, the following IPOs might be under pressure.

In short, the key is to do a fundamental analysis when picking IPOs, preferably fast-growing industry leaders with distinctive businesses in high-growth sectors. In general, IPOs with good fundamentals perform well. After picking out companies with good fundamentals, we can then value them and analyze the market sentiment to make the final decision. In our next class, we'll introduce how to increase the chance of IPO allotment.