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S&P's IPO and Small-Cap Picks In an online chat, analyst Mark Basham outlines a prudent approach The supply of new issues coming to market keeps increasing, says Mark S. Basham, an equity analyst at Standard & Poor's. However, many of these companies have immature business models and insubstantial revenues and profits. S&P has chosen to specialize in Internet infrastructure IPOs -- companies providing equipment or software that helps businesses go on the Internet. It's avoiding E-commerce offerings right now, says the analyst. Investors should not get too caught up in opening-day hype of IPOs, Basham warns, as they almost inevitably fall when demand lets up. That's why he advises investors to wait at least a few days or weeks before buying them. And, don't hold onto them too long, he says. You should take profits within six months. Basham discussed these and other issues relating to IPOs and small-cap stocks in a chat hosted by Business Week Online on America Online on July 27. Here is an edited version of Basham's responses to questions from the online audience and Business Week Online moderator Jack Dierdorff. A complete transcript is available on BW Online on AOL, keyword: BW Talk. Q: What's your diagnosis of -- and prognosis for -- the current market? A: I think the reason we've had the sell-off recently is because many of the large-cap tech stocks that led the spring rally already reflect the good second-quarter earnings that most of them have reported. Therefore, investors are taking profits. For the rest of the year, I think there are better values in small-cap and mid-cap stocks than in the large-caps. Basically, I am looking for small- and mid-caps to play catch up for the rest of the year so that the gains in the S&P 500 as well as the mid-cap 400 and the small-cap 600 are all in the low teens, basically around 12% or so. Q: How's the IPO market doing? A: There continues to be a dramatic increase in supply of new issues coming on the market. However, many of these companies are of lower quality. By that I mean, their business models are immature, they have very little revenues, and profits are only a dream in the distant future. Nonetheless, it appears that individual investors continue to ignore the risk and bid up the prices of many IPOs to unsustainable levels on the first day of trading. Often these individuals end up with losses from chasing after these IPOs. Q: With that generous supply of new issues, do you look at all of them? A: Right now, S&P is concentrating on what is coming to be known as the Internet infrastructure, in other words, companies that provide equipment or software that helps businesses go on the Internet. We are steering clear of E-commerce stocks -- companies that offer some type of service or product for sale over the Internet. Recently, leading E-commerce companies such as Amazon.com, eBay, and American Online reported second-quarter earnings that were in line or better than expectations, but their stock prices fell anyway. This is again most likely because investors are taking profits in these stocks because they were driven up to such high levels. Many of these Internet stocks are 40% to 60% below their highs reached only a month or two ago. Q: What are some of your favorite IPOs, both recent and upcoming? A: I still like Extreme Networks, which makes switches for the Internet. The company is growing very rapidly. Revenues in the next year should be up 120%, and earnings should rise six-fold. Upcoming IPOs I like include Foundry Networks and E.Piphany. I like Foundry Networks for the same reasons that I like Extreme Networks. They make switches that are used to connect companies to the Internet. This is a very high-growth business. Revenues are more than doubling each year. E.Piphany makes a software package that helps businesses target customers better. Businesses are able to offer the products that people want on the Internet and provide better service based on each customer's individual purchasing preferences. Q: Is UPS's upcoming IPO a good investment? A: I haven't seen the information for the offering. However, UPS is also an Internet play in that they deliver many of the packages of products that people order online. I think that aspect of the offering will be what investors are looking for when they start to look at the growth prospects for UPS. That has nothing to with whether the economy is strong or weak because the Internet will keep growing regardless of economic conditions next year. So the outlook for UPS, I would say, initially is pretty good. Q: Please name your top three small-cap picks. A: Basically, S&P's favorite small-cap stocks are ones that have attractive growth characteristics but don't trade at the very high valuations that many of the large-caps do. The first company I would name is Univision Communications (UVN). It is the largest Spanish-language broadcaster in the U.S. Its audience is growing very rapidly, and this is pushing revenues from advertising higher. We've recently raised the stock from accumulate to strong buy. We also like a company called Xircom (XIRC). It provides solutions for people to connect to networks away from the office and at home when they are telecommuting. In the second quarter, the company's revenues rose 45%, and earnings were very strong. The stock trades at a very attractive multiple of earnings of about 16. A third stock we like is Zebra Technlogies, which makes printers that print bar codes on almost everything you see them on. They had a great second quarter as well. We are looking for earnings of $2.13 this year and $2.50 next year. This stock also trades at an attractive price-to-earnings ratio of about 16. Q: Any small-caps or IPOs in the biotech sector that intrigue you? A: Yes, we have several biotech stocks we like including Millennium Pharmaceuticals. This company is focused on gene therapy among other things. We also like Liposome Company, which uses lipids [basically fat cells] to deliver drugs into the body. We have strong buys on both stocks. Q: What do you think of the NYSE IPO coming out in November? A: The stock exchange is waiting for the IRS to make sure that the members don't get hit with a big tax bill if they go public. But if they do go public, the offering will probably do quite well. The New York Stock Exchange is by far the largest and most important stock market in the world, and with the capital that it gets from its IPO, it will probably be able to stay in the No. 1 position. Q: Are IPOs in general a fast-in/fast-out investment, or should the average investor look to hold? A: No, IPOs are not good long-term investments in general. You should take profits fairly soon after they go public, no later than six months. One of the reasons is because usually six months after they public the insiders at the company are able to sell their shares. It is very unusual for an IPO to have bad news right after they go public because management has a pretty good idea over the short-term what to expect so they pick a time to go public when the news is going to be good. After that, it is not such a sure thing. Q: Why don't IPOs come out at their "offered price"? A: IPOs start trading at a completely different price than their offering price based on the supply and demand for the stock. Oftentimes right at the first trade there is incredible demand and this causes the stock to shoot up. But, once that demand is met, the stock usually falls back. So it is basically just supply and demand. That is why individual investors should just wait a few days or even weeks and you'll be able to buy these stocks at better prices. For example, the MP3.com offering last week skyrocketed on its first day, but it is already back down to 45. Edited by Lori Bongiorno
EDITED BY RICHARD S. DUNHAM
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