After a stalling for a long time, the IPO market finally got into gear last year. Perhaps the biggest factor was the rebound in Facebook (FB), which created enthusiasm for tech offerings like Twitter (TWTR).
Buying big bank stocks is the obvious way to capitalize on this trend, but is it necessarily the best way?
If history is any indication, buying larger bank stocks is a pretty good strategy. Whenever there is a strong bull market — which is always the case when IPOs are on fire — then the Wall Street bank stocks will inevitably reap lots of profits.
No doubt, there are many players, ranging from large firms like Goldman Sachs (GS), JP Morgan (JPM) and Morgan Stanley (MS) to smaller operators like Piper Jaffray and Stifel. But the larger bank stocks tend to get the bulk of the haul. Let’s face it, when a company goes public, it wants to select a top-notch firm; it’s a sign of power. Besides, it certainly helps to create investor interest in the deal.
As a sign of how lucrative an IPO can be, consider that the typical fee is about 7% of the amount raised. This can start to add up, especially when a typical deal ranges from $100 million to $200 million.
Now it’s true that mega offerings have much smaller fees. For example, Facebook’s was only 1.1%. So, it would not be a surprise if, say, the Alibaba offering also had a low percentage. But then again, when there are billions raised, even low fees can still bring in hundreds of millions of dollars.
IPOs can also lead to further add-on business. Often, a company will have several secondary offerings. There will also be opportunities to generate fees from mergers & acquisitions transactions, as well as wealth management services (after all, many executives and employees will get rich when their companies go public).
All of this sounds great, right? But there is a problem: Large investment banks have diverse business segments. So even if there is a surge in IPOs, the impact on bank stocks could be muted.
Take a look at Goldman Sachs. Last year, the company booked revenues of $34.2 billion. While the IPO business doubled, it still only came to about $1.1 million. Keep in mind that the revenues were dwarfed by other parts of GS, such as asset management, lending, trading and so on.
But there’s actually another way to play the IPO boom. Instead of turning to big bank stocks, look at private equity firms such as Blackstone (BX), KKR (KKR), Carlyle Group (CG) and Apollo Global Management (APO). Consider that the key part of their business models is generating profits from the IPOs of their portfolio companies.
While all of these firms are top-notch, the standout is BX. Founded in the late 1980s, BX now manages a whopping $266 billion in assets.
To see the power of the business model, consider the investment in TRW Automotive (TRW), which began a decade ago. During the period, BX restructured the operations and added bolt-on acquisitions. By late 2013, the return came to about 7X, or an average annual gain of 28%.
But of course, BX has been busy with many other IPOs. Some recent examples include Hilton Worldwide (HLT), SeaWorld Entertainment (SEAS), Brixmor Property Group (BRX), Burlington Stores (BURL) and Extended Stay America (STAY). It’s a good bet that, over the next few years, these will result in more gains as the firm sells off shares.
The IPO boom helped to boost revenues of BX by 63% in 2013 to $6.6 billion, and BX earnings spiked by 66% to $1.9 billion. Yet the stock is still selling at a reasonable valuation, with the price-to-earnings ratio of 16X. Oh, and the dividend yield is a juicy 7%, which compares to only 1.3% for GS and 0.6% for MS.
So if you want to get in on IPO profits, avoid the big bank stocks and buy BX stock, instead.
Tom Taulli runs the InvestorPlace blog IPO Playbook. He is also the author of High-Profit IPO Strategies, All About Commodities and All About Short Selling. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.