9 Reasons Not To Buy An IPO (Strategy and Why They Are Bad Investment)
Some IPOs go on to be multibaggers, like for example Facebook, Amazon, and Netflix, to name the most successful, but this article provides you with 9 reasons not to buy an IPO. For every IPO success, many more failures tend to be forgotten. The losers mainly don’t catch any interest from the media. The truth is that the median IPO performs poorly.
In this article, we look at 9 reasons why you shouldn’t participate in an IPO and why an IPO is a bad investment. The fact is that most IPOs fail and as a group, they underperform the market the first three years after the IPO.
What is an IPO?
In every case, investors have burned themselves on IPOs, have stayed away for at least two years, but have always returned for another scalding. For as long as stock markets have existed, investors have gone through this manic-depressive cycle.
– Benjamin Graham
An IPO is an abbreviation for Initial Public Offering.
The name implies what the purpose of an IPO is:
A company goes public, ie. gets listed on a stock exchange, and the public is offered the chance to purchase shares in the company. Almost always, new shares are issued as part of the IPO.
An IPO is strictly regulated by the Securities and Exchange Commission (SEC) – there are many requirements that need to be ticked off. Because of this, both an IPO and the subsequent stock exchange listing are costly.
Why do an IPO?
The main reason for an IPO is to get new capital for expanding the company’s business. Or, as you’ll understand after reading below, an IPO is an “easy” way for the insiders to cash out:
Sometimes the IPO is part of an exit strategy for the founders of the company. Many have worked long hours for many years, which is their chance to realize some gains from their project.
9 reasons not to buy an IPO
Investing is very much about avoiding mistakes and allocating your capital where you stand the best chances of good long-term results.
We believe that IPO is not a good place to park your capital for these reasons:
IPOs underperform
The fact is that IPOs underperform as a group.
Jay Ritter, an academic at the University of Florida, has over many decades collected data of the IPOs done during the last 50 years. Most of this data is compiled in his database. If you are interested in this topic, this database is a treasure.
What does Ritter’s data say?
His data suggests that most IPOs are underpriced and experience gains on the first day of listing. This is the “hot issue” phenomenon:
Measured from the offering price to the market price at the end of the first day of trading, IPOs produce an average initial return that has been estimated at 16.4%. Furthermore, the extent of this underpricing is highly cyclical, with some periods, lasting many months at a time, in which the average initial return is much higher.
However, Ritter refers to another anomaly: in the long run, initial public offerings appear to be overpriced.
He argues IPOs are overpriced because the three-year performance is lower than the overall market:
I find that in the 3 years after going public these firms significantly underperformed a set of comparable firms matched by size and industry.
You can read more about the historical returns for IPOs in the long and short run in our article about IPO trading strategy.
Average investors can’t buy the initial IPO price
You, as an average investor, most likely can’t participate in the IPO price. Thus, you need to pay up on the first day of listing if you want to buy and later risking underperforming over the next three years as the data above suggest.
IPOs are untested business models
It makes sense that IPOs underperform in the years after the listing. Most IPOs have a new or unproven business model, and thus many fail.
This is how capitalism works: it’s all about trial and error. Only a few succeed, and the winner takes more and more of the market.
We believe you are better off buying shares in companies with a proven business model. Or perhaps even better, buy a mutual fund and make sure you are properly diversified.