Investing in an initial public offering (IPO) can be tricky. There's often lots of hype, and it's easy to get caught up in the emotion of the moment. After all, most companies look amazing in their registration documents.
That's why it's often better to wait a few quarters and evaluate a company's performance in the public arena and perhaps take some of the emotion out of what can be an important investment decision. If a company truly has the potential to compound shareholders' returns over the long haul, it will still be a good investment, even at a later date. By contrast, if I'm compelled to buy shares of an IPO to avoid missing out on all the upside, then I'm either thinking too short-term or it's not that great an investment in the first place.
That's the main reason why most IPOs don't land in my portfolio. But they do occasionally land on my watch list. Three recent IPOs I'm watching are GoodRx Holdings (NASDAQ:GDRX), Peloton Interactive (NASDAQ:PTON), and Lemonade (NYSE:LMND). But remember: Investors should purposely watch the companies on their watch lists. Here's why I believe these stocks belong on your watch list.
Great businesses simultaneously solve problems for multiple parties. In this way, GoodRx is a great business. Its app helps users find the lowest price for prescription drugs in their area, making treatments more affordable. Not only is this beneficial for users, but it's also helpful for pharmacies because high-priced prescriptions are often left unpurchased, resulting in waste. Furthermore, doctors benefit since more of their patients will take their recommended medicine.
GoodRx could become a cash cow. In the first half of 2020, the company enjoyed a staggering 95% gross profit margin. Its biggest drags on the bottom line are sales and marketing expenses at 45% of revenue, but this is money well spent. Monthly active consumers grew at a 59% compound annual growth rate from the beginning of 2016 to the end of 2019, and 80% of all revenue currently comes from repeat customers. These factors lead me to believe that at some point, GoodRx will be able to dial back marketing spend and turn on the profits.
The stock has a sky-high valuation at 40 times trailing sales. Sales are quickly growing, with revenue up 48% year over year through the first half of 2020. But I'm not sure the growth rate justifies the price tag: If the price per share doesn't move, it would take about 3.5 years of revenue growth at the current pace just to reach a price-to-sales valuation of 10. I admit stock valuations have soared this year in general, but there was a time when many investors believed even 10 times sales meant a stock was expensive.
When valuation is the only concern, that's not a great reason not to buy; many of the best investments look overvalued at the time. But in the case of GoodRx, I have another concern. Its business primarily centers around prescription drugs, and prescription-drug pricing is a big political issue right now. Both presidential candidates are vowing reform, and it could potentially diminish the need for GoodRx's services. Therefore, this is a rare case where I would wait to see the new policy direction (if any) after the election.
It's hard to believe, but Peloton has been a public company for a mere 13 months. Over that time, its stock crushed the market, returning nearly 400%, and for good reason. Revenue is growing at a triple-digit pace, and its products allow users to exercise at home, which is important in this coronavirus-impacted year. But this is far more than a hardware company. Each equipment sale starts a (pricey) monthly subscription to Peloton's high-margin video content.
Some investors note that gyms have been operating at limited capacity in 2020. What happens to Peloton's pandemic cohort of users once lower-priced gyms reopen? This concern may be overblown. The company's customer retention metrics were off the charts before the coronavirus: The current 12-month retention rate is 92%. But at its IPO, management said 92% of all-time Peloton customers still had active subscriptions. In other words, there's good reason to believe the pandemic cohort will be loyal for years to come.
I don't believe Peloton is a recession-proof business, however. The company notes its hardware products are most often financed through third-party credit providers, and new customers could have a hard time securing financing in a deep recession. With a real economic threat from the ongoing coronavirus looming, Peloton remains on my watch list for now.
I'm not worried about hopping on the bandwagon too late. The company is aiming for 100 million users long term, up from just about 3 million users now. Perhaps the goal is lofty, but even hitting 20 million or 30 million users would leave significant upside. Therefore, I'm comfortable watching from the sidelines.
If you're looking for a noncyclical investment, an insurance stock like Lemonade is a good idea. Launched in 2016, this company is built on artificial intelligence (AI). The beauty of AI is its ability to quickly perform menial tasks and calculations, freeing up human capital.
According to the company, a typical insurance provider can only handle 150 to 450 customers per employee. By contrast, Lemonade currently has over 2,000 customers per employee thanks to its tech. In short, this is a business that can scale well.
Every industry has specific noteworthy metrics, and insurance is no exception. One key metric to watch is the loss ratio. Let's say an insurance company collects $100 in premiums but then has to pay out $67 to claims from customers. In this scenario, the loss ratio is 67%, which is what Lemonade's was in the second quarter of 2020. This was a dramatic improvement from the 82% ratio it had in the same quarter last year, and the 113% ratio it reported in 2018. This clearly demonstrates its technology is getting better at writing policies. That said, 67% still isn't a great ratio (loss ratios for established insurance companies run between 40% and 60%). Therefore, investors should continue to watch this metric in coming quarters.
Of the three companies on this list, Lemonade is the one I'm most interested in today. That's because the loss ratio is already headed in the right direction. Furthermore, Lemonade's IPO was priced at $29 per share but it opened around $50 per share. Therefore, right now you can Lemonade stock for about the same price as when it opened back in early July. If this young company is set to change the insurance game, this entry point looks as good as any.