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Should You Invest in Initial Public Offerings (IPOs)?

Investing

A lot of new investors get excited about investing in initial public offerings (IPOs) and the financial media strokes this excitement to generate stories that sell.

I understand the buzz. Just like you, I’ve heard stories about Google stock being purchased for next to nothing during the IPO, allowing an investor to realize huge fortunes as the company (and stock price) grew exponentially.

Yes, it would be great invest in successful companies at the ground level, but it’s not that easy. If it were, everyone would be able to identify the next great corporation in advance, purchase the stock early, and retire young.

If you are looking for an over-hyped recommendation on finding the next big IPO, you might not care for the remainder of this article. If you are looking for factual information on IPO investing, please continue reading.

How do IPOs Perform?

There is a substantial body of research that examines the investment performance of initial public offerings. Within this research, two clear trends emerge:

1) IPOs are underpriced on the first day of trading

Recall from my previous article on IPOs, an investment bank typically underwrites each IPO and purchases all primary shares from the issuing company. The investment bank then sells the shares at a higher price to institutional investors and other targeted groups.

The investment bank wants to accomplish two things in this process:

  1. Sell 100% of the new stock issue – to prevent holding the stock and tying up investment capital
  2. Make institutional investors happy with their purchase – by seeing the stock price increase

The easiest way to accomplish both goals is to underprice the stock during the underwriting process.

Source: Jay Ritter

Research has shown this to be accurate, and Dr. Jay Ritter, known as “Mr IPO,” has been studying IPO performance for decades. He makes much of his research publicly available on his website.

Since the 1960’s, IPO stocks have offered an average first day gain of 18% – 19%. The only explanation for this incredible performance is that the stock was undervalued by the investment bank during the underwriting process.

Can you guess who benefits from this? The institutional investors who purchase the original issue directly from the investment bank. Individual investors almost never receive initial IPO access and are therefore unable to capture any of this exceptional first-day performance.

One exception to this rule is Motif Investing, which offers original issue IPO shares to individual investors. If you are able to secure shares before trading begins, you can actually take advantage of any potential underpricing by selling your shares after the first-day trading concludes.

2) IPOs underperform other stocks following the first day of trading

What if you’re able to purchase IPO stock early? What is the long-term performance over the next five years?

Dr. Ritter has your answer:

Source: Jay Ritter

This table confirms the point discussed above – IPO stocks perform well for the first six months (driven largely by performance in the first day).

Following that time period, things get ugly. Compared to other publicly traded stocks of similar size (“size-matched” in the table), IPOs underperform by a large margin. In the first year after going public, these stocks underperform by 4.5%. It gets even worse in year two, and remains negative throughout the entire five year period.

The implications here are clear – institutional investors win on the first day of trading, while everyone else (holding shares after that day) loses.

Investing in IPOs – Conclusions

How can we reconcile the two findings discussed in the previous section? I believe these trends can largely be explained by irrational optimism on the part of investors (Dr. Ritter agrees).

Stocks should be valued according to company earnings and profitability. If instead, IPO stocks are traded in speculation, pricing can be driven well above the underlying fundamental value of the firm (explaining the huge first-day performance). This speculation could arise because there are a few massively successful IPOs each year (think Google, Apple, Amazon), and many investors are overly optimistic that every IPO will be the next big winner.

As optimism fades (6 months seems a reasonable amount of time), investors become aware that the stock price is not supported by underlying earnings, and many try to sell their shares. This causes the share price to fall and drives the subsequent underperformance that is observed.

If you want to invest in IPOs and you are unable to purchase primary shares issued by an investment bank, you should expect poor investment performance. If you think it’s an enjoyable exercise in stock picking, set aside a small amount of money to play with and enjoy yourself.

But if you are looking to build long-term wealth, purchase broadly diversified index funds and avoid investing in IPOs.

Editorial Disclaimer: The editorial content on this page is not provided by any of the companies mentioned, and has not been reviewed, approved or otherwise endorsed by any of these entities. Opinions expressed here are author’s alone.

User Generated Content Disclosure: Responses are not provided or commissioned by the bank advertiser. Responses have not been reviewed, approved or otherwise endorsed by the bank advertiser. It is not the bank advertiser’s responsibility to ensure all posts and/or questions are answered.

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