Invest in spinoffs and avoid IPOs when you look for new companies on the stock market. This should boost your long-term portfolio returns

The decision to go public or remain private depends on a number of factors that a company’s owners must evaluate from the unique perspective of the firm:

The main reason that a company sells shares to the public through an initial public offering (IPO) is to raise capital by reaching a large number of investors. This capital could be used for any number of things—from funding growth by acquisition to the expansion of existing operations or research to paying down debt. Share capital is also generally cheaper than debt financing for new companies on the stock market.

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Discover the truth behind IPOs so you can avoid the negatives of new companies on the stock market and keep your portfolio stable

IPOs can generate publicity for a company, drawing attention to its products or services. This can lead to expanded market share. Publicly traded shares can also provide a more liquid form of executive and employee compensation than shares in a privately held firm.

Share offerings are often used to provide company founders with an exit strategy, letting them cash in some or all of their interests in a private company. Venture capitalists who helped fund early growth may also put pressure on a company to go public as a way of getting out of their investments.

However, there are negatives in going public.

The upfront costs of an IPO can be significant. Underwriters’ commissions are typically 4% to 7% of the proceeds of the offering; and their expenses are added on to that. A company will also incur other offering expenses, including legal, accounting, printing and filing fees.

After the IPO, the cost of complying with regulators is high. This includes new fees for things like financial reporting documents and investor relations departments. Companies must subsequently make ongoing extensive disclosures to regulators and stock exchanges, and must submit to stringent rules and regulations.

What’s more, having public shareholders can put pressure on a company’s management to focus on short-term results instead of long-term growth. It also puts management and director compensation under public scrutiny, along with corporate governance practices and so on. In addition, the potential for lawsuits against management and directors for mismanagement is increased. The company and its executive team can be prosecuted for self-dealing, making material misrepresentations to shareholders or omitting information that securities laws require to be disclosed.

Look for spinoffs instead of IPOs if you want to invest in new companies on the stock market

New stocks coming on to the market can also be in the form of a spinoffs, which are a much better investment option.

We can say without reservation that, in investing, spinoffs are the closest thing you can find to a sure thing. It all comes down to the incentives.

Companies issuing new stock as spinoffs can involve incentives that work in your favour. This is easier to understand if you contrast spinoffs to one of the least desirable investments, new stock issues, or IPOs, where the incentives work against you.

When a company carries out a spinoff, it sets up one of its subsidiaries or divisions as a separate company, then hands out shares in the new company to its own shareholders. It may hand out the shares as a special dividend, or give its shareholders an opportunity to swap shares of the parent company for the shares of the newly established spinoff.

Study after study has shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years.

Target spinoffs when you look for new companies on the stock market that can unlock hidden value for you

One of the ways a company can try to unlock its own hidden value is by creating a separate company out of a subsidiary. The parent company can either sell the public stock in the new company (most often through an initial public offering) or spin it off; i.e., hand the stock out to its own investors. In the past few years, it has become common to do both.

Sometimes, the parent company first starts by selling a portion of the new company to the public, to establish a market and a following among investors. That way, by the time of the spinoff, stock in the new company may be liquid enough to be sold relatively easily, or retained with some confidence as a worthwhile investment.

In our experience, and in most academic studies of the subject, both the parent and the new company created by the spinoff benefit: they generally do better than comparable companies for at least several years after the spinoff takes place.

Bonus tip: Take advantage of our three-part Successful Investor approach to find the best new companies on the stock market

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

Some new stocks that come to market are nothing more than stock promotions. Have you ever invested in a stock promotion and sold right before it went bad?

How often do you buy new stocks as they come to the market? How is that working for your portfolio?