Should You Invest in an IPO?

by Michael on Jun 5, 2013 · 10 comments

Image of IPO on Chalkboard

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.

If last year’s Facebook (FB) IPO taught us anything, it’s that IPOs don’t always go up. In fact, if you look at the data, it appears that they may lag the market in the longer term.

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.

1 Midlife Finance June 5, 2013 at 1:18 pm

My dad lives in Thailand and he always invest in IPOs. He can get a certain amount of shares from his brokerage (underwriter) at opening price. He just sell them ASAP and make 30-150% in a day or two.
I don’t like investing in IPO because I can’t get pre IPO pricing….

2 A Blinkin June 5, 2013 at 7:53 pm

I don’t like the idea of investing in IPOs (unless you know something that everyone else in the world doesn’t). In an IPO, the company is essentially trying to maximize their value, so I don’t ever see it as a buying opportunity.

3 Paul @ The Frugal Toad June 5, 2013 at 10:42 pm

I wouldn’t invest in an IPO, there is too much uncertainty about the true valuation of the company. I only invest in companies that have solid management teams with a track record of returns.

4 SB @ One Cent at a Time June 5, 2013 at 11:21 pm

I haven’t bought an IPO yet. Mainly due the fact that they are not so accessible to us, general public. Some IPOs are exception to the law of average, like Google for example.

5 Little House June 6, 2013 at 9:37 am

When Facebook went public, I had a feeling it was going to be a dud. They still haven’t really secured a good way to make income – that was there downfall. IPO’s are definitely a risk unless you have an inside track.

6 Duane Buyron Carlson June 17, 2013 at 12:51 pm

Your comment “IPO for idiots. So sad. Ignorance. Dumbhiet.

7 Michael June 17, 2013 at 1:08 pm

Duane: It’s hard to make sense of your comment, but it seems clear that you disagree. That’s fine. But the numbers don’t lie. Yes, of course it’s possible for people to hit it big on a specific IPO. But the simple fact is that, on average, IPOs tend to underperform for an extended period.

8 Martin June 18, 2013 at 11:03 pm

in general I would agree with you, but it depends on what stock IPO you are looking at. Although I also am baffled who invested in FB at $40 a share, but on the other hand I invested into Visa IPO when it was around 55 or so and then later when the stock dropped to 44 a share. Then I sold at 60 or so, because I couldn’t sustain the mood of investors dumping the stock because of credit card fees cap (which obviously had nothing to do with Visa, but explain it to the idiots at Wall Street). Today I am kicking my butt for not sticking to my strategy. True, at that time I had no strategy so there was nothing to stick to. But I wish this stock would suffer some major decline so I could buy back in.

9 Michael June 18, 2013 at 11:13 pm

Martin: Even in the scenario you described, you would’ve been better off sitting tight and buying it post-IPO. True, that’s not always the case, and none of us have a crystal ball. But still. The IPO pop is far from a sure thing.

10 Martin June 18, 2013 at 11:18 pm

Michael, I agree and I do not invest in IPOs also. And yes there were a lot better opportunities post IPO. (I actually didn’t buy IPO, but post IPO, the very first trading day). To buy IPO you need a lot of money which I do not have.

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