I almost titled this piece “IPOs Are for Idiots,” but ultimately decided against it. That wording is, perhaps, a bit strong. But (imho) it’s not too far from the truth.
Of course, this doesn’t stop the media from getting whipped into a frenzy about big-name IPOs, and the investing public (as a whole) isn’t too far behind. So what’s the deal? Should you try to get a piece of the latest IPO?
Before we going any further, I just want to make sure that we’re on the same page. In case you weren’t aware, the term IPO is short for initial public offering. An IPO is the first public sale of stock by a (formerly) private company.
IPOs allow companies to raise capital (e.g., to fuel their expansion) and also provide company founders and early investors with an opportunity to cash out. But they also bring closer scrutiny, increased reporting requirements, etc.
While IPO pricing is generally linked to some sort of perceived valuation, the goal often seems to be to strike a balance between raising cash and generating buzz. In fact, many IPOs seem to be initially underpriced, resulting in a huge amount of excitement about the company (at the cost of lost capital for the issuer).
This apparent underpricing results in the famed “IPO pop,” in which prices spike once trading commences. That’s all well and good, but you have to have early access to the IPO to realize the full benefit of this — and most “regular” (i.e., you and me) investors don’t have such access.
Note: For the record, Facebook experienced a ca. 10% pop but promptly retreated. As of this writing, it’s trading for a little over $23/share vs. an IPO price of $38/share. That’s about a 40% decline.
But what about in the longer term?
Well… Academic researchers have argued (see, for example, this article and references therein) that IPOs actually underperform relevant benchmarks over longer time periods — by as much as 25-30% over the three years following the initial offering, with the period of underperformance extending to at least five years.
Interestingly, aside from the initial pop, there’s often another (smaller) bump in prices associated with the expiration of the quiet period. This is when company insiders, analysts, etc. are allowed to start talking about the company’s prospects, issuing earnings predictions, etc.
In other words, once the cheerleaders are allowed back into the discussion, share prices tend to rise a bit. But after that? Well, once the lockout period expires, share prices tend to exhibit a period of “abnormally negative” performance.
What’s the lockout period, you ask? That’s the period during which company insiders — those who arguably know best about a company’s prospects — are restricted from selling shares. Once that expires, they’re free to do as they wish. And the general tendency for prices to decline indicates that they often unload shares.
While these latter effects aren’t enormous, think for a minute about what they mean. When those who have the most at stake are allowed to start talking up the company, they do so — and share prices react favorably. But when they have a chance to put their money where their mouth is, you get the opposite outcome.
Do yourself a favor. Don’t believe the hype.