Investing in an IPO (initial public offering) can be as exciting as it is terrifying. You’re basically putting your money into a new company (at least to the eyes of the public) and hoping you guess correctly.
In this article, I'm going to cover whether IPO investors usually beat the market or not, so you can determine the right strategy for your investment portfolio. Let's first start by unpacking exactly what an IPO is.
What Is an IPO?
An IPO is an initial public offering. You may also hear it as a company "going public." In an IPO, a private company lists its shares on a stock exchange. It makes them available to the general public. Many people see IPOs as money-making opportunities. However, as you'll see below, there are both pros and cons to this ideology.
High-profile companies get a lot of media attention, with huge share price gains in public. This often causes a lot of reactions in the market, and the price may take a while to correct itself within the markets.
How Do IPOs Work?
Filing for an IPO is a long and complex process. For the sake of understanding, here are the key steps simplified:
A private company planning an IPO must submit paperwork and financial disclosures to meet the requirements of the Securities and Exchange Commission (SEC), which oversees public companies. During this time, there is also a lot of public scrutiny.
Hiring an Underwriter
Private companies hire an underwriter, usually an investment bank, to consult on the IPO and help decide on the offer's initial price. Underwriters also issue shares to investors. The company's shares begin trading on a public stock exchange such as the New York Stock Exchange (NYSE) or the Nasdaq.
Once the company is appropriately valued, a red herring (more on this below) is created. The IPO is then sent to the market for people to buy. Note, many shares will have already been sold to private investors before the company goes public, so the stock price (and the rights attached to that share) you see publicly may be a lot different than what other private investors receive.
To Buy, Your Broker Has to Deal with IPOs
You have to work with a brokerage firm that handles IPO orders to buy shares. Not all brokerages handle IPO orders. If you know someone at the company or investment bank, you may be able to buy directly from the underwriter.
You must also fulfill certain eligibility requirements, such as a minimum account value or a certain number of transactions carried out within a certain timeframe. However, you may not be able to buy shares at the initial price of the offer. Retail investors usually cannot buy shares when an IPO stock starts trading, and by the time you can buy, the price can be much higher.
Why Do Companies Have IPOs?
There are a lot of good reasons why companies have IPOs. Here are a few:
To Let Early Investors in the Company Cash out Their Investments
Many original investors might want to sell their shares, and an IPO gives them the opportunity. Remember, most companies going public are already fairly large companies with multiple investors, not necessarily "public" investors.
Companies Can Raise More Capital by Selling Shares to the Public
When a company goes public, it can open investment up to the entire public, thereby increasing the chances of capital flowing into the business. This is the most common reason companies go public - to scale. The proceeds can be used to expand the business, finance research and development, or repay debts. Other ways to raise capital, such as venture capitalists, private investors, or bank loans, can be too expensive.
Going Public in an IPO Can Provide Companies with a Huge Amount of Publicity
Companies may want the status and "gravitas" of being a public company, which could also help them secure better terms with lenders. Being a publicly traded company allows the company to get eyes on it in both good and bad ways. Good because they'll have new investors, but bad (or I should say "challenging" because of the new restrictions and requirements of being a publicly traded company).
Key IPO Terms
If you're looking to invest in an IPO, there are a few key terms you should know about:
- Common stock: Units of ownership in a public company that typically entitle holders to vote on business matters and receive dividends from companies. When a company goes public, it sells shares of common stock.
- Issue price: The price at which shares of common stock are sold to investors before an IPO company begins trading on a public exchange. Commonly referred to as the offer price.
- Lot size: The smallest number of shares you can bid on in an IPO. If you want to bid on more shares, you have to bid multiples of the lot size.
- Preliminary prospectus: A document created by the IPO company providing information about its business, strategy, historical financial statements, recent financial results, and management. It has a red letter on the front cover’s left side and is sometimes called the red herring.
- Price band: The price range in which investors can bid on IPO shares, determined by the company and the underwriter. It is generally different for each investor category. For example, qualified institutional buyers may have a different price band than retail investors like you.
- Underwriter: The investment bank handling the offer for the issuing company. The underwriter generally determines the issue price, publicizes the IPO, and assigns shares to investors.
Reasons Why IPO Investors May Not Do Well
In most cases, you're not going to beat the market as an IPO investor. YCharts did some in-depth research on IPOs and found some interesting information:
You're Typically Better off With Index Funds
Although it seems exciting to be an early investor, the data shows you are better off just investing in the market about two-thirds of the time. YCharts considered the hypothetical of an investor choosing between an IPO or an S&P 500 index fund. They found in 62% of the time, the S&P 500 index fund outperformed the IPO.
IPO Performance Seems to Be Worsening
They also found major IPOs have gradually worsened in keeping pace with market returns over the last 10 years. They looked at IPOs launched in Q1 of 2019 and compared it against returns of the S&P 500. Annually, the S&P 500 outperformed the IPO by about 24%.
The spread between the most successful and least successful IPOs in a year is also widening. The best IPOs perform to a higher degree, and the opposite is true for the worst IPOs. Finally, YCharts found only IPOs in health care and technology have outperformed and they've done so by a relatively small margin.
Unprofitable Companies Continue to File IPOs
Profit doesn't necessarily mean value. But it can also cause a tricky valuation and investment with IPOs. Unprofitable companies file more and more large IPOs.
From an investment perspective, it makes it hard to argue for investing in IPOs, particularly for unprofitable companies. While the media hype and public opinion may boost the stock price, after it corrects itself, you might find yourself at a loss.
You Can't Beat the Market
I don’t care what anyone says. I stick with JL Collins in saying long-term, nobody beats the market. At least consistently or with any formula. Studies show ”beating the market” is not possible for most people.
Additionally, some argue we are currently experiencing an IPO bubble, which would mean company valuations at the IPO time are being inflated. This means those who buy shares at the time of an IPO are less likely to see a return on their investments.
Ways in Which IPO Investments Can Be Effective
Despite the evidence against investing in IPOs, there are opportunities to play the market and come out ahead. Here are some ways that you may be able to invest effectively with IPOs:
- Avoid the hype. Waiting for the initial hype to die down often works well, often several months after trading begins. This will allow the stock to begin to price more appropriately in the market as people buy and sell for what the stock is worth. That gives you a better and more realistic opportunity to make a profit.
- Watch the news. Pay close attention to all the good news from a new public company and its reaction. Suppose you believe strongly in a company, and your fundamental and technical analysis convince you it's a good purchase. In that case, you should stick with it. Especially if the public sentiment is negative it might create an opportunity for a massive gain.
- Know the lock-up period. This is when insiders must keep their holdings before selling, and it is usually between 3 and 24 months. A company with a longer lock-up period may scare some investors off. Still, it might also be a buying opportunity for those who can bear the risk.
- Get the right brokerage. Establishing an account with a brokerage firm underwriting IPOs or receiving an allocation from the issuer can lead you to eventually get the shares of a new company at its offering price. Maybe you don’t get all you want, but it can be very profitable. TD Ameritrade is one such brokerage, and they’re one of the best brokerages overall, too.
Compare Discount Brokerage Accounts
The evidence is stacked pretty high against investing in IPOs. That being said, it doesn’t mean there isn’t a golden opportunity for making a profit with IPOs. You have to do your research, time the purchase right, and stick to your guns. There’s a chance you’ll lose out on some, but remember stocks like Facebook and Apple were at one time an IPO.