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Be wary of the undercurrents when investing in a public flotation

INVESTORS can get very excited about IPOs (initial public offerings) and M&A (merger and acquisition) activity, which has been booming over the past year.

But not all generate positive returns for shareholders. IPOs that initially do well tend to be priced at a discount to fair value, and one important factor driving longer term performance is whether the incentives of the sponsoring company are aligned with investor interests.

It is well known that M&A tends to benefit the target more than the buyer - the target gets a premium on day one, but the buyer bears all the risk of executing its strategy and extracting synergies, which do not always succeed.

Both strategies present problems for private investors.

When it comes to IPOs, choosing those which are attractive and then getting a reasonable, or any, allocation of shares can also be challenging. With respect to M&A, identifying the potential targets is, of course, very difficult. The hype surrounding the Royal Mail float may encourage people to think that buying shares when a company floats is a surefire way to make money but investors should be careful not to get their fingers burnt.

They must be aware that companies always float for a reason. One reason could be to maximise profit for the company's current owners, and as with any share investment, investors should consider how well their own interests will be served by the deal. Investors can seek a third way. In the recent past some companies have created shareholder value by divesting divisions. These companies tend to be easier to identify (management teams announce their intentions) and controversies such as price, regulatory issues and anti-trust (competition law) are easily identifiable.

Our research suggests that, instead of focussing on those companies that hit the headlines because of M&A activity or IPOs, investors should seek out companies that are about to divest part of their existing assets.

Despite huge public interest, just over half of IPOs over the last 12 months were down in price one month after trading, but companies that have divested divisions have outperformed their peers.

The highest profile example is Vodafone's $130bn sale of its stake in Verizon Wireless and huge return of value to shareholders.

Also in the telecoms sector, Cable and Wireless has benefitted from the divestment of Monaco and Islands (M&I) and Macau divisions over the last two years.

Another recent example is insurer RSA, which has benefitted from the sale of several small, non-core divisions for greater than book value.

Also in the financials space, when Phoenix sold Ignis Asset Management to Standard Life, both Phoenix and Standard Life shares outperformed when the deal was announced.

We have identified some companies that could be the next to divest assets.Reckitt Benckiser has been trying to sell its pharma business for some time - a successful divestment (such as an IPO) could help Reckitt Benckiser shares.

We also believe Smiths Group could benefit from the sale of its medical division. BG Group could benefit from the further sell-down of its stake in QCLNG (the Australian liquid natural gas business) and the sale of a stake in its Brazilian assets.

Vodafone could outperform if it is able to IPO its Indian business, which is a possibility in 2015.

Companies that divest divisions appear to be creating significant value for their investors, which may make them a better bet than high profile flotations.

Nik Stanojevic is an equity analyst at Brewin Dolphin

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