Why 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. But these 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 have been 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 IPOs. From 1980 through 2017 over 70% of IPOs had positive returns on their first day of trading. And 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 after the first three years 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 2 and reinvesting the proceeds in a market index fund. Even more interesting is the fact that share price performance over their first three years of existence seems to have been correlated with the sales volume of the company. Those with inflation-adjusted sales below $10M trailed the market by over 45%, while those with sales between $50M and $100M lagged by only 16.7%. The largest IPOs (those with over $10 billion in sales) actually outperformed the market by 7% over the three years following their IPOs.

Why have IPOs behaved this way? Based on the two primary drivers of stock prices, company earnings and investor sentiment, one could logically surmise that it would have to be investor sentiment that is largely responsible for any first-day gains. After all, future company performance at that point in time is highly uncertain. That’s also very likely why companies are so selective in choosing the right investment environment in which to go public. They want to maximize the excitement that accompanies the introduction of a new technology or innovative business model so as to get the biggest market bang. But then, after three years, the stock price becomes more reflective of the reality of the company’s business performance. At the same time investor mood has likely cooled off, providing less of a boost to the stock’s P/E ratio and consequent price. If this is truly how things work, it would be no surprise that 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 the average IPO, you’d better acquire your shares before trading begins. That way you’d at least have a 70% chance of a gain, and possibly a big one. Waiting until day two to purchase them  – or even buying them on the open market the day the IPO starts trading – would likely cause you to miss any big run-up. And hanging on to the stock for any length of time is likely to cause you regret. Unfortunately, it’s not easy for the average investor to get hold of IPO stock, and when you can, it’s usually a small enough quantity that even if it were to double, it wouldn’t enable you to retire or to buy that yacht.

Here’s a link to Ritter’s data: https://site.warrington.ufl.edu/ritter/ipo-data/