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:
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.
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.
IPOs are cyclical
An intelligent investor in common stocks will do better in the secondary market than he will do buying new issues…The IPO market is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of public offering or in a negotiated transaction.
Warren Buffett, shareholder letter of 1993
Companies raise money when they can and less so when they have to. IPOs happen when the markets are frothy and full of optimism. In bear markets, where investors are careful, the insiders get less for their shares and many rather wait until the markets have improved.
Because of this, IPOs are cyclical and tend to happen in rising bull markets. This means IPOs are valued at high multiples. The odds are against you and you face a headwind fighting the optimism bias.
IPOs are expensive
Because IPOs mostly happen in rising or bull markets, the companies are valued at the high end. They are never cheap. Many insiders sell some of their holdings during the IPO – exactly what happened in Coinbase some months ago in 2021.
IPOs are never cheap no matter what the investment bankers say.
IPOs are hyped
Every IPO is hyped as the next Facebook or Amazon. But only a few succeed.
It’s important to understand that the investment bankers and underwriters of IPOs are salesmen.
The bankers travel around to hype the IPO and try to get as much attention as possible, and often tout the company as a once in a lifetime opportunity. It seldom is.
Private investors are not prepared
Every IPO comes with hundreds of pages of information. It says please read the offer document carefully before investing but rarely anyone does.
IPOs are not a level playing field
We believe the game is rigged against the small private investor. The wealthy investors bought shares before the IPO and get a tailwind from the IPO boost which many sell into. You can easily get lured into a loss-making IPOs by optimistic reports in the media.
Most companies don’t beat Treasury bills
It is entirely possible that you could use our mental models to find good IPOs to buy. There are countless IPOs every year, and I’m sure that there are a few cinches that you could jump on. But the average person is going to get creamed. So if you’re talented, good luck.
– Charlie Munger
Hendrik Bessembinder’s famous research paper from 2017 stated that just a small minority of the public companies go on to beat the market averages. You should look at IPO in the same way.
Don’t buy an IPO just because it’s an IPO, but rather because it’s a good investment.
Not all IPOs are bad
Please don’t get us wrong:
Not all IPOs are bad. Some go on to make spectacular gains. The problem is that it’s hard to know at the IPO date which one that is going to be. Investing is about getting the odds in your favor and we believe IPOs offer poor risk/reward.
Let’s keep in mind what the legendary investor Benjamin Graham wrote about IPOs:
Our one recommendation is that all investors should be wary of new issues—which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased. There are two reasons for this double caveat. The first is that new issues[IPO] have special salesmanship behind them, which calls therefore for a special degree of sales resistance. The second is that most new issues are sold under “favorable market conditions”—which means favorable for the seller and consequently less favorable for the buyer.
The evidence points out that IPOs, in general, are poor investments. There are many reasons not to buy an IPO!
IPO trading strategy – conclusion
The conclusion is simple: any IPO trading strategy will most likely fail unless you are short.