- An initial public offering,
when a successful private company
decides to offer shares to the public,
is an exciting time for the company,
its original shareholders, and the investing public.
All of the excitement and publicity around an IPO
often lead investors to want to get in on the action.
If you can get in on the ground floor of an IPO,
that is, get an allocation in the initial share offering
before the stock starts trading,
there is evidence that you are likely to make a profit.
IPOs tend to be underpriced.
While this might seem like an obvious way to easy profits,
there are a few crucially important things
for you to consider.
I'm Ben Felix, Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing,
I'm going to tell you why IPOs don't live up to the hype.
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It is well-documented that IPOs tend to be underpriced.
In other words, when the underwriter determines the price
that the company should offer its shares to the public,
the data show that they tend to set a price
below where the market will price the shares.
This creates the perception
of a real opportunity for investors
to make a quick profit on the first day of an IPO.
The media often enjoy reporting
on the large first-day profits that IPO investors make.
The challenge for most investors, though,
is that getting in on the initial allocation is really hard.
The majority of the initial allocation
generally goes to institutional investors,
which we will touch on again in a minute,
while the allotment for retail investors
is likely to be allocated to larger brokerage clients.
Fidelity describes the allocation process
for retail investors as follows.
Each customer who wants to participate in an IPO offering
is evaluated and ranked based on his or her assets
and the revenue they generate for the brokerage firm.
Typically, customers with significant
long-term relationships with their brokerage firm
will receive higher priority
than those with smaller or new relationships.
This statement from Fidelity is supported
by a 2018 paper in the Journal of Finance titled
"Quid Pro Quo?
What Factors Influence IPO Allocations to Investors?",
where the authors examined 220 IPOs
from January 2010 through May 2015
to test the determinants of IPO allocations.
They found strong support
for the brokerage revenues associated with a client
being a significant determinant
of investors' IPO allocations and profits.
Based on this, if you are able
to get in on an initial allocation,
unless you're a high value brokerage client
or an institution,
you're likely getting in on an IPO
with a poor expected outcome.
There is adverse selection in IPO allotments,
where those with expected weak first-day returns
have been easier to get access to ahead of time.
I think it's safe to say that, in general,
smaller retail investors and DIY investors,
who are not generating significant revenues
for their brokerage firm,
will be hard pressed to get in on the initial allocation
when a hot company goes public.
Interestingly, there is evidence that new mutual funds
use their institutional status and relationships
to get in on initial IPO allocations
in an effort to boost their returns.
This was detailed in a 2017 paper,
"IPO Allocations and New Mutual Funds"
by Frankie Chau, Yi Gu, and Christodoulos Louca.
They looked at data from 1998 to 2015,
and found that new mutual funds tend to outperform
during the first six months after inception.
This outperformance was concentrated
in new funds that held underpriced IPO stocks.
After the first six months, performance fell substantially.
The suggestion in the paper
is that a fund company might choose to allocate
all of their IPO allotment to a new fund
in an effort to boost its performance
to attract new investors.
While this works to get an initial boost,
the fund performance tends to drop off quickly.
The reason that this information
is relevant to our discussion
is that it shows the level of competition
for initial IPO allotments.
I wouldn't take this as a signal
that all new mutual funds will perform well.
Keep in mind, it is easy to identify the funds
receiving preferential IPO allocations after the fact,
but I wouldn't start speculating on new mutual funds
in an effort to profit from this phenomenon.
All right, so you're probably not going to get in
on the initial allocation when a company goes public,
but that doesn't mean that you can't buy shares
on the first day of trading.
Once the shares are listed on a stock exchange,
many of the people holding the shares
will want to realize the profit
from the likely underpriced IPO,
and you could be the one to buy them.
The performance of IPOs after the first day of trading
has also been studied extensively.
In the March 2017 paper,
"The Long-Term Performance of IPOs, Revisited,"
Daniel Hoechle, Larissa Karthaus, and Markus Schmid
detailed the performance of US IPOs between 1975 and 2014.
They looked at a total of 7,487 IPOs
over time periods ranging from one to 40 quarters
after the first trading day.
They found that IPO firms tended to behave
like high beta stocks
with negative loading to the value factor,
and that they underperform for the first two years,
even when common risk factors
like size, relative price, and momentum are accounted for.
This underperformance gradually declines
with longer time periods,
becoming statistically insignificant after two years.
In summary of their paper,
IPO firms have unfavorable exposure to risk factors,
with high betas and negative loading to value,
but even when those are accounted for,
IPO firms tend to underperform for the first two years.
These findings are also supported by more recent research.
In a 2019 paper from Dimensional Fund Advisors,
the authors examined 6,362 US IPOs
between January 1991 and December 2018.
To evaluate IPO performance as a whole,
they constructed a hypothetical
market-cap weighted portfolio of IPOs
issued over the preceding 12-month period
and rebalanced monthly.
They excluded first-day returns from the analysis.
They found that, over the full sample period,
the IPO portfolio delivered a return of 6.93%
with a standard deviation of 27.62%,
while the Russell 3000 Index, a US total market index,
delivered a 9.13% return with a 14.28% standard deviation.
They also split the full sample period into two sub-periods,
with one ending in the year 2000
to isolate the high volume of IPOs over that time period.
The result for both sub-periods,
before and after the year 2000,
exhibited underperformance relative to the market
with substantially more risk,
as measured by the standard deviation of returns.
This result corroborates the findings
of Hoechle, Karthaus, and Schmid,
who found that IPOs perform poorly over the first two years.
The Dimensional paper also applied
the Fama/French five-factor model
to the IPO portfolios' returns,
and found that the returns are well explained
by the factors in the model,
market beta, company size, relative price,
profitability, and investment.
This suggests that IPO firms as a group
have behaved like small cap growth stocks
with weak profitability that invest aggressively.
These types of stocks, whether they are recent IPOs or not,
tend to underperform the market.
What we can conclude from the research
that we have discussed in this video is that,
if you want to make money from IPOs,
you have to get in on the initial allocation,
but doing so, especially for hot IPOs,
is really unlikely, unless you are considered
a highly valued client by your brokerage.
If you are able to get in on the initial allocation,
there's a good chance that it's not an IPO
that will have a big first-day pop.
The better the expected pop,
the more likely the IPO shares will be allotted
to institutions and the largest retail clients.
If you miss out on the initial allocation,
and instead buy the shares on the secondary market
once they've started trading,
you're buying into shares that will likely perform
like a small growth, low profitability,
high investment firm,
which have an unattractive risk/return profile.
Even beyond that, let's keep in mind that,
any time that you buy one stock,
you probably aren't going to get the returns
of the asset class that it belongs to.
On average, a secondary market IPO investment
will give you the poor expected outcome
of small growth, low profitability, high investment stocks.
But unless you are building
a diversified portfolio of recent IPO stocks,
your actual outcome on an individual stock investment
will be driven by the specific risk of the company,
which delivers a random outcome.
Thanks for watching.
My name is Ben Felix of PWL Capital,
and this is Common Sense Investing.
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