May 14, 2013

Every investor's dream is to get in on the ground floor of the next Apple or Google well before such companies become huge success stories and their stocks soar in value.

While the rewards can be great, the odds of success are usually low. "IPOs [initial public offerings] are a very risky segment of the market," says Brian Berghuis, manager of the Mid-Cap Growth Fund. "For every success there are dozens of companies that meander through their corporate lives or outright fail. So it's important to ferret out the rare company that may at least have the potential for major success."

A recent T. Rowe Price study shows how difficult that can be. It tracked some 4,500 companies that went public from 1995 through 2007 and measured their progress through the end of last year.

Of those with less than $100 million in revenue at the time of their IPO, representing about three-quarters of the total, about 40% had attained that level through last year, and only one in 20 had reached $1 billion in revenue, marking a major milestone.

Of the roughly two-thirds of more seasoned companies that went public with more than $100 million in revenue over this period, only a third had reached the $1 billion mark in revenues through 2012. (The study did not account for companies that were bought out sometime after the IPO.)

And while many investors might expect to find these diamonds in the rough in such high-powered and high-profile industries as technology and health care, some of the best success rates were found in relatively less dynamic sectors such as energy, industrials, telecom services, and consumer discretionary—proving innovation can be found throughout the economy.

Success Rates for IPOs in Reaching Revenue Milestones

The companies in the chart below went public between 1995 and 2007 with less than $100 million in revenue and reached at least $1 billion in revenue over this period, including household names such as and Yahoo!, but the list also includes relatively less recognized firms such as Wild Oats Market, Atlas Pipeline Partners, Steel Dynamics, and Quanta Services.

While T. Rowe Price invests mainly in companies with established track records, the firm has participated in the IPO market for decades and is one of the largest investors in that arena. The firm's equity analysts examine virtually every IPO that comes down the pike—many even before the IPO while the companies were still private.

Some Leading IPOs by Revenue Growth in Various Sectors
Companies that went public from 1995-2007 with less than $100 million in revenue
Security Name IPO Year Revenue in Fiscal Year Prior to IPO (in millions)** Most Recent Annual Revenue (in millions)** Market Capitalization (in billions)**
Consumer Discretionary
Wynn Resorts 2002 $1.16 $5,154.28 $11.79 1997 15.75 61,093.00 119.98
Consumer Staples
Agria 2007 64.33 1,089.06 0.04
Wild Oats Market 1996 98.52 1,183.02 Acquired
Atlas Pipeline Partners 2000 3.54 1,203.98 2.13
Williams Partners 2005 40.98 6,729.00 17.65
SL Green Realty 1997 8.77 1,476.67 7.45
E*TRADE Financial 1996 23.42 2,186.93 3.06
Health Care
Alexion Pharmaceuticals Inc. 1996 0.14 1,134.11 16.89
Illumina 2000 0.47 1,148.52 6.21
Quanta Services 1998 49.13 5,920.27 6.05
Stericycle 1996 21.34 1,913.15 8.25
Information Technology
Equinix 2000 0.04 1,895.74 10.32
Yahoo! 1996 1.36 4,986.57 23.76
Steel Dynamics 1996 0.14 7,290.23 3.35
Compania de Minas Buenaventura 1996 91.56 1,563.53 6.51
Telecommunication Services
Crown Castle International 1998 31.41 2,432.68 20.46
Nextel Partners 2000 32.72 1,801.65 Acquired
Note: The study was ended in 2007 to allow companies the ability to have five years of operating history. Companies are ranked by the largest percentage increase in revenue from the time they went public through the most recent fiscal year.
*Split-Adjusted IPO Price
**As of 2/28/2013
Market Capitalization: Price multiplied by shares oustanding. Uses quarterly shares outstanding for U.S. companies and fiscal year shares outstanding for non-U.S. companies. When retrieving the most current market value the latest intraday price available is used.
Of the stocks listed in the above chart, the following securities represented 2.40%, 10.25%, 0%, 1.20%, 0.69%, 1.32%, 1.29%, and 1.74% of the Mid-Cap Growth, Media & Telecommunications, Small-Cap Value, New Horizons, Small-Cap Stock, Global Technology, Science & Technology, and New Era Funds as of March 31, 2013:, E*Trade, Alexion, Illumina, Quanta Services, and Crown Castle International.
Sources: FactSet and T. Rowe Price.

On average, the firm participated in about 40% of all IPO issues over the past four years. In fact, about 25% of all U.S.-listed stocks that T. Rowe Price owned as of December 31, 2012 (excluding those in index funds), were originally invested in as IPOs over the past 20 years, although some were not owned continuously since the company went public.

T. Rowe Price IPO Participation

Even picking "winners" that soar in early trading, however, has negligible impact on fund performance initially because of the relatively small position a fund may take in the stock. But, over time, as managers' confidence and investment in these unproven companies increase, some have become significant contributors to shareholder returns.

The firm typically views IPO investments as potential long-term holdings rather than as an opportunity to turn a quick profit. Several dating back to the 1990s remain in portfolios today.

Indeed, T. Rowe Price's reputation for taking a long-term perspective on investing in newly minted companies, rather than "flipping" their stocks for short-term gains, is one reason the firm is often wooed by those going public.

IPO Importance

"IPOs are a very important part of the investment process here," says Preston Athey, manager of the Small-Cap Value Fund. "First of all, you don't want to miss the next potential big investment opportunity. Also, you learn about possible threats to your other companies. So we expect our analysts to examine every IPO in their industries to know what's going on in that industry."

Hugh Evans, an IPO specialist and member of the Investment Advisory Committees for the Small-Cap Stock and Small-Cap Value Funds who has examined more than 1,000 IPOs over the past 18 years, adds: "It's crucial to focus on the next generation of potential breakout companies. Over time they could potentially account for such a large portion of a portfolio's return."

For example, Evans cites another T. Rowe Price study showing how relatively few stocks can drive performance over time. From 1985 through 2012, the Russell 2000 Index of small-cap stocks had an annualized return of 12.6%. If the top 10% of performers in the index were excluded, the return would have been just 2.6%.

T. Rowe Price Long-Term Holdings Acquired in Initial Public Offering (IPO)
Based on IPOs prior to 2008 ranked by market capitalization
Company Name Industry Year of IPO Market Capitalization (in millions)* Last Fiscal Year Revenue (in millions)
Google Internet Software & Services 2004 $264,379 $50,175
Wal-Mart Food & Staples Retailing 1970 237,679 444,948 Internet & Catalog Retail 1997 119,979 61,093
UPS Air Freight & Logistics 1999 78,765 54,127
Goldman Sachs Capital Markets 1999 71,960 41,170
eBay Internet Software & Services 1998 70,795 14,072
Gilead Sciences Biotechnology 1992 64,899 9,703
Time Warner Media 1992 49,554 28,729
Mondelez International Food Products 2001 49,144 35,015
Express Scripts Holdings Health Care Providers & Services 1992 46,574 93,972
Las Vegas Sands Hotels, Restaurants, & Leisure 2004 42,399 9,411
Starbucks Hotels, Restaurants, & Leisure 1992 41,077 13,300 Internet & Catalog Retail 1999 34,367 5,261
VMware Software 2007 30,793 4,605
American Tower Real Estate Investment Trusts (REITs) 1998 30,659 2,876
And Some More Recent T. Rowe Price IPO Investments
Based on IPOs from 2008-2012; Top three each year ranked by market capitalization
Company Name Industry Year of IPO Market Capitalization (in millions)* Last Fiscal Year Revenue (in millions)
Visa IT Services 2008 $105,027 $10,489
Rackspace Hosting Internet Software & Services 2008 7,697 1,309
Colfax Machinery 2008 4,083 3,914
Dollar General Multiline Retail 2009 15,232 14,807
Mead Johnson Nutrition Food Products 2009 15,169 3,901
Cobalt International Energy Oil, Gas, & Consumable Fuels 2009 10,031 0
Tesla Motors Automobiles 2010 3,684 204
Oasis Petroleum Oil, Gas, & Consumable Fuels 2010 3,424 687
LPL Financial Holdings Capital Markets 2010 3,351 3,661
Kinder Morgan Oil, Gas, & Consumable Fuels 2011 38,392 9,973
LinkedIn Internet Software & Services 2011 18,272 972
HCA Holdings Health Care Providers & Services 2011 16,438 33,013
Facebook Internet Software & Services 2012 64,637 5,089
Workday Software 2012 9,178 274
Realogy Holdings Real Estate Management & Development 2012 6,520 4,672
*As of February 28, 2013
Market cap is calculated as price multiplied by common shares outstanding.
Sources: FactSet and T. Rowe Price; excluded General Motors IPO in 2010.

Based on his own analysis of IPOs over the past decade or so, Henry Ellenbogen, manager of the New Horizons Fund, which invests in small growth companies, says: "Only a few outliers actually get to $1 billion of sales. Just 3% have what it takes to become large-cap companies, and about half of them become road kill. So if we find one of those companies with the potential to be an outlier there are two challenges. One is identifying them, and the second one is holding onto it, and I would argue that the second is actually harder than the first."

Another key reason the firm spends a lot of time studying new companies is to gain insight into possible threats to existing holdings.

"Every IPO is a possible threat to current portfolio holdings," says Dan Martino, manager of the Media & Telecommunications Fund. "When you have a new company with a potentially disruptive business model, you'd better be familiar with it if you own one of their competitors. But even if you don't, it just helps you avoid blindsides and making mistakes over time."

Tom Watson, a computer software analyst and member of the Investment Advisory Committees for the Global Technology, Science & Technology, and New Horizons Funds, adds: "That perspective is especially important in software where the rate of change now is the highest it's been since we switched from mainframes to client servers in the 1980s. One reason for that is cloud computing.

"So, it's really important to keep track of what's happening at the private company level and the small public company level because, first of all, there are potentially great investment ideas, but also because it impacts what's happening in our mid- and large-cap software holdings."

Keys to Success

While the criteria for evaluating newer companies can vary from one industry to another, there are certain characteristics managers consider crucial. Having a solid business model and an innovative product or service with expansive market potential is important, but the quality of the firm's management comes above all else.

"In small companies, it's the number one, two, three, and fourth consideration," Evans says. "Most of these companies will live and breathe to the rhythm of an entrepreneur with a vision."

Jack Laporte, former manager of the New Horizons Fund for 23 years, adds: "I've seen good managements make mediocre businesses very good stocks and bad managements turn good businesses into disasters."

Berghuis says, "We want managements that are passionate and understand the pathway to potentially becoming a much larger company, as well as their own limitations, as well as companies that drive innovation in potentially large markets. They may not be there today, but they could be there over the next five years."

In searching for small companies that could eventually graduate to the firm's mid- and large-cap funds, Ellenbogen focuses on two key attributes. "One is a fundamentally better business model or something that's replicable and they continue to innovate—in essence, business model innovation. One example is Panera Bread. They figured out how to provide better-quality, fresher food at lower cost that creates greater customer satisfaction and how to appeal to more of a customer's daytime experience. So now it's commonplace to have Wi-Fi in a restaurant, but when they did it they were unique.

"The second is, do they have an Act II that goes beyond the initial business model. A classic example is Paychex. Act I was doing payroll for small to medium-size businesses, but Act II was tax and ancillary services, and that actually proved more profitable than the first act. So, the question I ask myself before investing in a small company is: Could it cross this chasm and have an Act II? A lot of times that determines whether or not I hold the stock."

In an effort to identify companies "where the end market is ripe for disruption," Ellenbogen focuses on six areas in particular: corporate technology, media convergence, health care information technology, genomics, financial payments technology, and collaborative and aggregate data businesses.

In the fast-changing computer software industry, Watson says the most successful IPOs generally "have been those with some sustainable advantage besides the pure technology itself. Software is a great business because in part there are minimal capital requirements. But this also means the low entry costs create a very dynamic structure, so we try to analyze the durability of growth.

"Sometimes you find a software company that is gaining market share because it can perform a process slightly faster than the last generation," Watson adds. "I'm more cautious on those because if there is no differentiation, in a few years there will be an even faster alternative.

"Sometimes, a software company looks like it has a terrific innovation, the stock goes up 50%, and then all of a sudden a new competitor arrives and within a year the growth rate falls to 10% and the stock is down by as much as it gained the year before. We obviously try to avoid those, but you can't avoid them all."

In the energy production arena, where hydraulic fracturing and horizontal drilling are creating new opportunities in shale gas and oil exploration for both established and newer companies, Shawn Driscoll, an energy analyst and member of the Investment Advisory Committee for the New Era Fund, says: "We spend most of our time on the basins themselves, sifting through well information to figure out who has the best rock. So when a company goes public we have a good hunch whether they are in the good part of the basin or the bad part.

"But overlaid on top of that is the know-how and the technology involved in horizontal or unconventional oil drilling, which is changing a lot," Driscoll adds. "This really only started in earnest in '06 and so the same phenomena that created the shale gas boom are now creating the shale oil boom.

"As a result, we always focus on the rock first and then the people, because you can have very smart people, but if they don't have good geology it won't be a good stock. You just can't make bad rock look good, but there's plenty of people who have made good rock look bad. That's why we try to focus on both, and even then we may only be successful about half the time."

While innovation is often a hallmark of new companies, Evans notes that, "Sometimes, innovation counts more in sectors that don't have it than in those that do." One example he cites is 3-D Systems, which has become the leader in the dynamic 3-D printing industry.

"They introduced a major, innovative technology into the tool and die manufacturing industry that hadn't seen innovation in 50 years," Evans says. "And 3-D printing is still in the early stages of development. We think it has significant potential."

An IPO Potpourri

With such a broad range of industry expertise, T. Rowe Price managers have uncovered many interesting opportunities to invest in newer companies throughout the economy, including some that have already evolved into industry leaders and others that are forging new breakthroughs.

To illustrate how the firm has put its theories into practice, here is a glimpse of a handful of IPOs it has participated in over the years in various sectors.

Consumer: "People naturally assume innovation resides primarily in the tech and health care sectors," Berghuis says, "but it can be found in various sectors; the consumer sector has been a big one over time."

One of the firm's longest-held companies bought on its IPO is Whole Foods Market, the natural food supermarket chain that went public in 1992. As a young analyst then, Berghuis believed in the company's future even though Wall Street viewed it "as a really narrow niche, almost a fringe, hippie concept," he says.

In a memo to the firm that year, Berghuis wrote: "I do not view natural foods retailing as a fad. It appeals to the baby boomers' interest in health and wellness. As consumer concern about nutrition grows, several natural foods retailers, including Whole Foods, are moving into the cultural mainstream."

At the time, there were only 25 natural foods supermarkets in the U.S. "We had a deep understanding of this nascent industry, and I thought the market could expand significantly," Berghuis now recalls. In addition to the company's potential market growth, Berghuis was intrigued with its chief executive, John Mackey.

"John Mackey ranks up there with the top CEOs I've ever known in terms of thought leadership, innovation, openness to new ideas, and his ability to manage people and create a culture that was highly differentiated," Berghuis says. "So we had a company led by a passionate entrepreneur with a truly unique outlook and strategy. Whole Foods represented a huge innovation in what had been a fairly stodgy supermarket industry."

Today, T. Rowe Price remains among the company's largest shareholders. That confidence was tested when Whole Foods stock plummeted almost 90% from its peak in late 2005 into the financial crisis before recovering. T. Rowe Price took advantage of the decline to add to its position.

In his new book, Conscious Capitalism, Mackey credits the firm for not only sticking with the company, but giving it encouragement during those dismal years.

In the midst of the crisis, "T. Rowe Price told us over and over again that it really believed in the business and in its long-term potential," Mackey writes. "To paraphrase, [the firm advised], 'Don't do anything now that you will regret later…To us, this represents the kind of relationship a public company should strive to have with its investors—one based on mutual respect, transparency, honesty, support, patience, and trust."

Other consumer-oriented companies that found new ways to innovate that the firm has participated in from the start include longtime holdings Panera Bread, Starbucks, and such recent investments as Angie's List; OpenTable, the leading electronic restaurant reservation platform; Allegiant Travel, a discount airline focusing on smaller, less competitive markets; and, the leading online video site in China.

Social Media: The firm invested in Facebook even before it went public. While that has not been as rewarding as expected, what the firm learned from doing its due diligence on that company bolstered its confidence to invest in the unique market opportunity offered by LinkedIn, a professional social networking company, when it went public two years ago. In contrast to Facebook, LinkedIn has exceeded expectations.

"People felt Facebook would create significant pressure on LinkedIn's business model," Martino says. "Our work on Facebook made us realize that this was not the case, and now people understand that they are different companies in different industries.

"LinkedIn is more of a business services model. Like Facebook, they are benefiting from the shift from physical to digital advertising, but that accounts for just a quarter of their revenue. The balance is in recruiting services for HR [human resource] professionals. They are really disrupting the traditional HR recruiting model. This company has basically invented a new industry."

As part of its research, T. Rowe Price convened a panel of HR professionals from various companies familiar with LinkedIn's services to gain their insights firsthand. "It was clear from that discussion," Martino says, "that they thought this service was incredibly good and that it enabled them to do something they couldn't do before—hire the most attractive candidates more efficiently, including those who were only passively looking for jobs."

Computer Software: The software industry has been a fertile area for IPOs recently. Watson says 18 of the 34 companies he now covers were invested in at the IPO stage in recent years.

"We need to follow these companies from an early stage because even though the numbers are small, the impact can be very large. I know that not all 18 of our current software IPOs will make it to mid-cap or large-cap land, but if one or two do that's a big success."

One of Watson's five "sources of durability" for software companies is, simply, to "do something that's really hard." Among the more promising companies in this category is Workday, which has become the HR software system of record for businesses, helping manage employee profiles and performance and benefit programs. It also provides financial and accounting services.

"What Workday does requires so much complexity that it creates a barrier to entry that we think will improve its chances of becoming a larger business over time," Watson says. It also did not hurt that Workday was started by the founders of PeopleSoft, which had a proven track record, and T. Rowe Price knew the management well.

Health Care: This industry has generally been a minefield for IPOs in recent years, but the firm has invested in some new companies with unique products or services that are doing well. One is Pacira, which went public in 2011.

This company produces a long-lasting anesthetic that can provide post-surgery relief for up to 72 hours compared with six hours for existing drugs. This helps reduce recovery days in the hospital and provides an alternative to such powerful medications like morphine, which is often used for postoperative care and can have damaging side effects.

Athenahealth and Pharmasset are two other stocks the firm invested in on their public offering six years ago. Athenahealth provides information technology services for physicians that help reduce administrative overhead and increase efficiency. Pharmasset developed a hepatitis C medication and was subsequently acquired by Gilead Sciences, adding a significant new growth opportunity.

Energy: The revolution in hydraulic fracturing, or shale oil and gas production, has made the U.S. the largest contributor to oil production globally in the last two years. "The United States has wiped out 18 years of oil production declines in two years just with shale oil production," Driscoll says.

"Not many people realize that the U.S. is now the third-largest producer of oil and natural gas liquids in the world. In terms of just oil, we'll pass Saudi Arabia within two years, and a year or two after that we'll pass Russia to be the largest. So we own a lot of companies levered to this."

While the field is dominated by established leaders, there has also been room for newcomers with attractive assets. One is Oasis Petroleum, a shale oil producer that went public two years ago.

"Oasis is a classic situation of how we get interested in IPOs," Mr. Driscoll says. "We had spent a lot of time in the Bakken field and we knew the economics of their wells, which is what drives these companies. So when the IPO was announced, we already knew the company and its assets very well."

Media: T. Rowe Price initially invested in Google on the public offering in 2004, recognizing its substantial growth potential in U.S.- and international-sponsored Internet search. It currently represents the firm's largest holding, accounting for $7.5 billion in assets alone. The bulk of this position, of course, was acquired in subsequent years after the IPO.

T. Rowe Price remains enthusiastic about Google's future prospects. "Over time they have proven to be very innovative and ambitious," says Paul Greene, an analyst who now follows the company.

"They do not rest on their laurels. They are always pushing the needle. They are the leader in so many of tomorrow's technologies and are well positioned in major growth areas. Their management team and willingness to think long term, aside from having a strong core business, leads us to believe that they will have continued success."

What Can Go Wrong

By being very selective and cautious, taking a long-term approach, and always doing its homework, T. Rowe Price overall has had its share of success in its IPO investing. But for various reasons, not all of these companies fulfill their promise.

"Your instinct is to blame it on execution," Martino says. "More typically, execution wasn't the issue. Maybe the dream was too big or competitors responded in a way that the company didn't anticipate."

Berghuis says, "Sometimes our judgment is faulty, sometimes the concept is worthwhile but the execution is faulty, and sometimes it's just bad timing. A lot of factors can intervene between the best laid plans and success."

Athey adds, "One of the things our analysts try to determine is whether there is something enduring about what the company does that gives you higher-than-average confidence they can keep it going, or is it just a flash in the pan."

In that regard, the jury may still be out on Groupon, but it represents one of the firm's biggest disappointments and misjudgments to date. T. Rowe Price invested in the Internet-based commerce company even before it went public in late 2011. It was one of the hottest tech IPOs, valued at $16.5 billion. Since then the company's stock has plummeted, its chief executive has been fired, and its market value has fallen below $3 billion.

"When investing in companies with grand visions within entirely new industries and strong early success, it is inevitable that we will sometimes be wrong, as we were with Groupon," Martino candidly wrote in a recent report to shareholders.

He adds: "The management execution certainly hasn't been good, but the market opportunity probably was not as big as we thought. We thought it had more legs, but the product saturated its potential and proved more faddish and trendy than a mainstream marketing channel…Consumers kind of got fatigued with it."

Despite such inevitable setbacks, and a marked decline in the number of IPO opportunities since the financial crisis, T. Rowe Price remains committed to this strategy.

Pace of IPOs Falls Dramatically

"It may be more challenging," Berghuis says, "and we may have more misses than major successes, but it absolutely remains an important part of our investment process. New companies are the lifeblood of public markets, so we have to stay focused on them."

Evans, who has spent most of his career evaluating IPOs, adds: "If you are not looking at potential breakout winners, you are not in the money management business."

All mutual funds are subject to market risk, including possible loss of principal.

As of March 31, 2013, of the stocks mentioned in this story showing IPOs that T. Rowe Price has invested in and still holds, those owned by the Mid-Cap Growth, Media & Telecommunications, New Era, Small-Cap Value, New Horizons, Small-Cap Stock, Global Technology, and Science & Technology Funds accounted for 4.84%, 23.93%, 1.92%, 2.74%, 10.76%, 4.62%, 10.21%, and 18.15% of their assets, respectively. The following securities were not owned by any of these funds as of March 31, 2013: eBay, Express Scripts Holdings, Gilead Sciences, Goldman Sachs, HCA Holdings, Kinder Morgan, LPL Financial Holdings, Mead Johnson Nutrition, Mondelez International, Paychex, PeopleSoft, Pharmasset, Realogy Holdings, UPS, Visa, and Wal-Mart. The manager's views and portfolio holdings are historical and subject to change. This material should not be deemed a recommendation to buy or sell any of the securities mentioned. The following securities mentioned in this story and charts were not owned by any T. Rowe Price fund as of March 31, 2013: Agria, Atlas Pipeline Parters, Compania de Minas Buenaventura, Nextel Partners, Wild Oats Market, and Williams Partners.

Charts are shown for illustrative purposes only and do not reflect the performance of any specific security. Past performance cannot guarantee future results.