Should You Invest in IPOs?

Should You Invest in IPOs?

Since the beginning of this year we’ve seen a number of spectacular first-day gains among Initial Public Offerings (IPOs). Lyft rose 21% before closing with a gain of 9%. Pinterest soared 25% but was overshadowed by Levi Strauss’ 31% advance. And even those impressive returns pale in comparison to Zoom, which – true to its name – zoomed up an astounding 72% by the end of its first day of trading. It’s no surprise that so many IPOs are oversubscribed. But are they really good investments?

Jay Ritter, a professor at the University of Florida, has been collecting data on IPOs for some time now and has uncovered some interesting facts about them. From 1980 through 2017 over 70% of IPOs experienced positive returns on their first day of trading. The average gain was 17.9%. That’s a pretty good track record! Clearly those investors who were able to get in on the ground floor stood to reap some pretty hefty rewards.

The picture becomes muddier over time, however. Ritter found that during the first three years after going public the average IPO underperformed the broader stock market by a cumulative 17.9%. In other words, you would have been better off dumping those IPO stocks on day two and reinvesting the proceeds in a market index fund. Even more interesting is the fact that returns during this period seem to have been correlated with company size as measured by inflation-adjusted sales volume. The stocks of those IPO companies below $10M trailed the market by over 45%, while stock performance of those with sales between $50M and $100M lagged by only 16.7%. The largest IPOs (companies with over $10 billion in sales) are the only ones that actually outperformed the market by 7% over the subsequent three years.

Why have IPOs behaved this way? As I have written before, the two primary drivers of stock prices are company earnings and investor sentiment. Since future company earnings at the moment a company goes public is highly speculative, any first-day gains would logically be driven primarily by investor sentiment. In fact, companies are very selective in choosing the timing of an IPO for just that reason. They want to maximize the excitement that accompanies the introduction of a new technology or innovative business model so as to get the biggest bang for the buck. Once the company begins operating publicly, and develops a track record, its stock price likely becomes more reflective of the reality of its business performance. And the level of investor exuberance experienced during the IPO is likely not maintainable over a multi-year period, putting downward pressure on the stock’s P/E ratio and consequent price. This could explain why the bigger companies tend to perform better over time than the smaller companies, which face much bigger risks. Of course, three years is a pretty short horizon over which to measure investment performance, but it’s the best data I’ve seen so far.

The takeaway for investors is that if you do want to participate in an IPO, you’d best acquire your shares before trading opens and sell them quickly after any run-up. Waiting until day two to purchase them  – or even buying them on the open market the day the IPO starts trading – does not appear to have been an effective strategy historically. In any case, it’s not easy for the average investor to get hold of IPO shares in the first place. And if you do get the opportunity, the amount is not likely to enable you to retire or to buy that yacht regardless of what the stock does.

Here’s a link to Ritter’s data:

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