Should You Invest in IPOs? Is It Worth The Risk?

Should You Invest in IPOs? Is It Worth The Risk? - Featured Image

In an initial public offering (IPO), a previously private company begins selling stock to the general public.

It’s one of the most exciting events in the world of finance. For the company, it brings a huge influx of attention and, of course, cash. For institutional investors and ordinary folks alike, it’s the first opportunity to own a piece of an attractive, promising, growing company.

So what’s the best way to invest in new stock offerings? And should you do it at all?

 

The (Second) Best Performing Asset of 2020 Was… 

Take a look at the following chart, tracking the S&P 500 index during COVID-19.

The S&P 500 index during COVID-19

(via Renaissance Capital)

Pretty solid, right? The stock market has performed remarkably well lately.

Now check out this next chart, tracking the performance of new issues against the S&P 500.

Performance of new issues against the S&P 500

(via Renaissance Capital)

Short of cryptocurrencies, initial public offerings–new companies entering the stock market–were the single best performing asset of 2020. Had you invested in Renaissance’s “IPO” index fund (a fund which tracks all IPOs) last Spring, you would’ve doubled your money already.

You just don’t see those kinds of returns in the stock market. Ever.

It kind of makes you want to invest in IPOs, right? Who wouldn’t want to double their money in a year?

IPOs are a genuinely exciting asset. And that’s why they’re so dangerous.

Even when the numbers look this good, you should always be wary of new stock market listings. Here are just a few reasons why:

 

Why You Should Be Wary of IPOs

  • You’re probably buying at the wrong time

Perhaps the most exciting new listing of 2020 was Coinbase, the cryptocurrency exchange. 

Investors saw Coinbase as an institutional (read: safe, familiar) gateway to the burgeoning ecosystem of cryptocurrencies. A way for Wall Street and Main Street alike to dip their toes where they were afraid to before. They also liked the company’s revenue numbers: 1.8 billion in Q1 2020 alone, a ninefold increase over the same period in 2019. It helps explain why, on its first day of trading, the company briefly topped 100 billion dollars in valuation.

That made Coinbase–the crypto exchange–50% more valuable than the New York Stock Exchange it was trading on that day.

These days, the picture looks a lot different.

Coinbase IPO

(via Yahoo Finance)

Coinbase is a lesson in how timing impacts new issues. Put simply: companies will always aim to go public at the precise moment it suits them. Cryptocurrencies were in an historic bull run when Coinbase announced their direct listing. Bitcoin’s all-time high came not one day after Coinbase went public. But when cryptocurrencies fell back down again, so did Coinbase.

  • You’re not just buying, you’re being sold to

At its core, the purpose of an IPO is to quickly raise a lot of money. To pull in the highest number possible, companies will be marketed heavily before their actual listing date.

This period is aptly referred to as the “roadshow.” The IPO’s underwriter (the investment bank handling the process) will travel around the country, around the world, presenting data, slideshows, videos, and Q&As to help drum up interest and media attention. This is part of the reason why IPOs can be so expensive: they’re the result of months of hype.

It’s as they say: IPO? It’s Probably Overpriced.

  • You may take a haircut after the “lock-up period”

Before becoming available to the public, all kinds of investors already own shares in a private company. There are the early investors–friends and family, angel investors, venture capital–as well as insiders who get preferential early access to the IPO.

Typically, these preferred parties are contractually obligated to hold their stock for a certain period of time (otherwise they might all sell the first day, causing a disaster). This “lock-up period” usually lasts 180 days, but it can be anywhere from 3 to 24 months.

Once lock-up is over, preferred investors can sell and take profit. More often than not, these folks own much more stock than your average Joe, so when they sell the price takes a hit.

If you’re clever, you might wait for the lock-up to end and then buy when the price is low.

 

The Key to Investing in IPOs

If you look at the historical data, it turns out there’s one really good way to invest in new issues.

Do it when nobody else wants to.

History has demonstrated time and again that the more new issues hit the market, the closer the market is to crashing. A footnote in Ben Graham’s “The Intelligent Investor” spells it out neatly:

In late 1967 the IPO market heated up again; in 1969 an astonishing 781 new stocks were born. That oversupply helped create the bear markets of 1969 and 1973-74. In 1974 the IPO market was so dead that only nine new stocks were created all year; 1975 saw only 14 stocks born. That undersupply, in turn, helped feed the bull market of the 1980s, when roughly 4,000 new stocks flooded the market–helping to trigger the overenthusiasm that led to the 1987 crash. Then the cycle swung the other way again as IPOs dried up in 1988-1990. That shortage contributed to the bull market of the 1990s–and, right on cue, Wall Street got back into the business of creating new stocks, cranking out nearly 5,000 IPOs. Then after the bubble burst in 2000, only 88 IPOs were issued in 2001–the lowest annual total since 1979.

For a visual aid, look to the following chart. There are 30 vertical lines, representing the 30 months in which IPOs yielded the highest returns.

Highest Months of IPOs

(via Seeking Alpha)

Every line occurs during a bull market, and every line ends just before a bear market. Past performance never guarantees future performance, but you’d be hard-pressed to come up with any metric more negatively correlated with the stock market than IPOs.

 

The Bottom Line

The most IPO-ey IPO ever was Facebook’s.

It was one of the most anticipated public offerings in history. Unlike most stocks, everybody knew what Facebook was, and why it was so successful, so ordinary people around the globe wanted to buy. To capitalize on that demand, Facebook increased the number of shares they’d be selling by 25%. Then they raised the price of each share well above the upper limit they’d planned for just weeks earlier.

But it wasn’t enough to stem the onslaught. Hundreds of millions of buy orders were placed even before the market opened that Friday, May 18th. It got so bad that, once trading finally did start, the Nasdaq outright crashed. Their technology couldn’t handle all the order flow, even though it had been stress-tested hundreds of times in preparation.

After a week, Facebook’s price per share had dropped from $38 to $28. After two months, $20.

It was a disaster. Too much hype caused a Black Friday-style mad dash, and when the system couldn’t take it everybody lost out.

In 2021, though, the event that was so dire then now seems like a silly memory. It only took a little over a year for the company to regain its initial valuation, and today they’re worth exponentially more.

In general, it’s smart to invest in good companies. But you don’t have to rush.

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