Are IPOs a Good Investment?

2013 was a huge year for the initial public offering, or IPO. With big brand names like Twitter and Hilton going public, investors poured more money into IPOs last year than in any year since the tech bubble.

In terms of the number of companies going public last year (156), you have to go back to 2007 to find similar volume.

Likewise, the $38.2 billion that firms raised in their initial offerings in 2013 made it the biggest year for IPOs in terms of proceeds since 2000, when companies raked in $64.9 billion from IPOs.

This is rather unsurprising given how the broad market performed during the year. The S&P 500 index, for example, was up 29.6%, meaning it was a lucrative time to go public from a valuation perspective.

However, with all this money flowing into new stock offerings, it begs a simple question:

Are IPOs a good investment?

Jay R. Ritter is the Cordell Professor of Finance at the University of Florida. He has been studying IPOs for the better part of 30 years and has authored dozens of papers on the subject.

In a recent paper published by the Journal of Financial and Quantitative Analysis (one of the top academic journals in the area of finance) Ritter, along with fellow authors Xiaohui Gao of the University of Hong Kong and Zhongyan Zhu of the Chinese University of Hong Kong shed some new light on IPOs in the United States.

Although the primary purpose of their work was to understand the reasoning behind the severe drop in the number of firms going public since 2000, their research also provided powerful insight into the investment performance of IPOs going all the way back to 1980.

Here are some of the interesting takeaways regarding the returns of the 7,440 IPOs they studied from 1980 to 2009:

  • The average first-day return for an IPO was 18.1%
  • When compared to other publicly-traded stocks of similar size and style, the average IPO underperformed by 7.2% during the three years after going public
  • Small companies, defined as firms with pre-IPO sales of below $50 million during the 12 months prior to going public, showed the greatest underperformance
  • Interestingly, the paper also cites other research indicating that the underperformance of small company IPOs is not unique to the United States. From 1995 to 2008, the average small company IPO in Europe reported a three-year buy-and-hold return of -27.5%.

So what does this mean for investors?

As a financial professional, I’ve seen the risks and realities of IPOs both in research and data, as well as firsthand working with the major custodians that make IPOs available to retail investors.

Here are the realities for the typical investor who might be trying to get in on the next LinkedIn, Facebook, or Twitter:

  • Most “hot IPOs” are oversubscribed. This means that unless you’re somehow very well connected, it’s unlikely you’ll receive more than a tiny allocation, if you get an allocation at all.
  • As Ritter’s data makes clear, with the exception of a possible short-term burst, most IPOs actually underperform, in addition to being much riskier than a more diversified strategy.
  • Most custodians maintain strict IPO “flipping” rules designed to prevent you from selling an IPO within the first 15 to 30 days after the stock begins trading on the secondary market. Thus, it’s very challenging to get in the business of harvesting the “first-day pop” that the average IPO often produces.
  • If you sell an IPO (or any other stock for that matter) within 12 months after purchasing it, you’ll be taxed at the short-term capital gains rate. This can cut into your return by anywhere from 25% to 50%, after you factor in surcharges and state taxes.

So unless you are good friends with an investment bank, can invest exclusively inside a tax-advantaged account, and are able to avoid getting flagged as an “IPO flipper,” the odds of being successful in the IPO market are not exactly in your favor.

As Ritter’s research makes clear, you’re better off investing in a more diversified equity portfolio, rather than trying to find the next Google.

Sources:

  1. Ritter, Jay R., “Initial Public Offerings: Updated Statistics,” January 31, 2014
  2. Ritter, Jay R. and Gao, Xiaohui and Zhu, Zhongyan, “Where Have All the IPOs Gone?” Journal of Financial and Quantitative Analysis December 2013

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