The initial public offering market is Hot![soros]
The IPO market is booming, with shareholders clamouring for newly listed companies.
2020 was a record year for IPOs, with $331bn raised globally; including 454 offerings worth $167bn in the US. This is miles ahead of the previous full-year record of $107.9 billion at the height of the dot-com bubble. Like 1999, the new listings are dominated by tech companies. However, SPACs have also become a popular part of the IPO scene.
Investors are desperate to get a piece of these new businesses. The average first-day return for IPOs in 2020 was nearly 42%, the best day-one showing since 2000. Some recent listings – such as Vroom, Airbnb and Lemonade – saw their prices pop over 100% on the first day of trading!
The History of Initial Public Offerings
While the recent news is full of excitement and optimism, long term history provides us with some deep and valuable perspectives.
One of my first jobs was working at a highly reputable equity manager in the shadow of the Dotcom Bust. After some heavy losses, the firm imposed a complete ban on participating in initial public offerings for all of its investors. By contrast, last year several of that same firm’s funds made over half of their returns from new listings!
This shows how short memories are in the world of finance. But look at the history, across different markets and different decades, and there is a consistent pattern to IPOs. As they say, history doesn’t repeat but it often rhymes. By understanding these cycles and learning from the past we can profit from IPOs and avoid the classic pitfalls.
The great thing about studying IPOs is there is so much data on them, going back decades and covering every conceivable stock market. This body of research contains far more insights than any individual could experience over a lifetime.
- The Classic US IPO study was by Jay Ritter in 1991.[i] He found that over the three years from the close price on the IPO’s first day of trading, the average IPO underperformed by more than 27%!
- A similar study by Forbes Magazine looking at nearly 2000 IPOs found that they underperformed the S&P 500 by about 12% per annum.[ii]
- Jeremy Siegel examined the returns for nearly 9000 US IPOs from 1968 to 2000, and reported that about 80% subsequently underperformed from the IPO date. Moreover, a large proportion of those recently listed did extremely badly, underperforming by more than 30% p.a. The few incredible performers (including Intel and Wal-Mart) could not make up for the vast majority of disasters. The study also showed that returns are particularly bad amongst those that IPO in hot markets, such as 1999 and 2000. The author concluded, “Investors who think they are getting in on the ground floor of a great opportunity are instead about to fall through the basement.”[iii]
- A more recent study by IPOX Schuster reported that, between 1985 and 2019, a portfolio of IPOs that were bought at the first day’s closing price and held for 48 months posted a median decline of 17.4%. Over a four year holding period, 57% of IPOs had negative returns.[iv]
While long-term performance is atrocious, what is interesting is that many of these studies have found big outperformance on Day One of trading. There is typically a 15-20% ‘pop’ on that first day; and sometimes more in stocks where there is great exuberance.
HOWEVER, there is a catch. To get the pop, you have to get in at the IPO price. This can be tricky as investment bankers tend to allocate most of the pre-IPO shares to large asset managers who are also their clients. The moment the stock actually starts trading, the pop may have already happened.
And one other thing to remember: to get the best returns, you have to sell after that first day pop. In fact, the evidence suggests, the bigger the first day pop, the worse the subsequent performance is!![v]
What is amazing is how consistent these patterns are. We’ve not only got data from the US, but loads of studies from the UK stock market[vi]; and similar results from, Germany, France, Mexico, Brazil, Chile, Spain, South Africa, Australia, Egypt and even Mauritius!
They all show the same pattern: A day 1 pop of 15-20%, followed by a long grind of underperformance totalling 15-50% and lasting anything from three to five years.
Why do IPOs Perform Like This?
The problem with IPOs can be summed up with one word: Over-optimism. IPOs are mostly done at times of great optimism both for the company and the wider market.
Furthermore, the very fact that companies can IPO indicates their industry is enjoying easy access to capital; and easy access to capital will mean more investment and more supply, which always ends in falling profitability.
In that regard, now seems a particularly inauspicious time to pick up an IPO. Corporate finance availability is at record levels and interest rates at all-time lows. Private equity is allegedly sitting on a $1.7trillion cash pile. Selling to a competitor or private buyer requires less regulatory hassle and expense than listing, and there may be synergies on top. So the only reason you would list now is you think the stock market will bid you an even crazier price!
It’s also important to remember that IPOs are sold by slick investment bankers and managements looking to cash out. These are smart people, with every incentive to foment the euphoria, get the IPO away at the best price and collect a handsome paycheque. This is the one point in the company’s lifetime when there is unlikely to be anyone giving the bear case. Inevitably, investors end up overpaying for the future.
When you buy an IPO, You should also remember who is on the other side of the bargain. You are likely to be buying stock from private long term owners who know their business inside out. No-one else is in a better position to understand their company’s ups and downs, the swings in sentiment and the true prospects for the enterprise. So when they sell, it is a sure-fire sign they believe this is as good as it gets, and they should know.
Often the IPO presentation and prospectus is full of all the recent good news but leaves out the bad news (or at least buries it at the back). For example, it will usually contain only two or three years of financials, meaning you won’t even see how the business coped in the previous cycle.
A Powerful Market Signal
Several studies have also shown that IPOs mostly occur in hot markets or hot sectors, where companies are already trading at abnormally high valuations. Subsequent results, not only in the recent IPOs but also in that whole sector or market, tend to be disappointing.[vii]
Indeed, a glut of IPOs has proven one of the most consistent indicators that a market or sector is nearing its peak. It can provide a valuable exit signal for canny investors.
The 60-40 End of a Proposition
Puggy Pearson, one of the 20th century’s most successful and colourful poker players, famously said,
“Ain’t only three things to gambling: knowing the 60-40 end of the proposition, money management, and knowing yourself.”
If we replace gambling with investing, this timeless quote is equally valuable. Sometimes markets offer us winners’ games; when valuations are low, caution prevails, and there are forced or mindless sellers. Winner’s games are great because even if you don’t have much luck or skill, you are still likely to come out on top or at least flat. By contrast, when markets are loser’s games you need a lot of luck or skill just to break even.
This is what knowing the 60-40 end of a proposition is all about. Knowing when a market is a winner’s game and you can step right in and enjoy it, and stepping aside when it becomes a loser’s game is more than half the battle.
With slick salesmanship, a euphoric backdrop and the asymmetry of information, IPO markets represent a loser’s game.
Broken IPOs: An exception to the rule?
‘Broken IPOs’ are a group of recently IPO-ed companies where I have found considerable investment success. A broken IPO is a company that has done dreadfully (typically this means down 75% or more) within a few years of the IPO. Two factors can make these especially good opportunities.
The first is that they tend to be flush with cash. Having raised a large sum from the IPO, most will have the financial strength to overcome any temporary setbacks.
The second is that they often become extremely undervalued. When a new listing does not meet its overhyped expectations, investors feel duped and embarrassed. They just want to get as far away from the shattered dream as possible. So they dump the stock at any price. But because the company is only recently listed, few investors are familiar with it, so there are no ready buyers; and any potential buyers are scared off by the collapsing price and lack of a record.
The overall result is that broken IPOs can become extremely cheap yet well-capitalised businesses.
Winning the IPO Game
- IPOs generally perform dreadfully after their first day of listing. This underperformance typically lasts several years. This is well documented across myriad stock markets and time periods, and there are good reasons for it: Euphoria, timing, salesmanship and asymmetry of information.
- The one exception is getting in at the pre-market IPO price, then selling within a day or so. Most IPOs will pop 15-20% on day one, before the underperformance starts.
- A large number of IPOs happening at once is a signal of overvaluation for either the market or a specific sector, and usually portends a bear market.
I think it is best to end with the wisdom of Ben Graham – the father of investment theory. Here is what his classic book on Investing, The Intelligent Investor (first published in 1949!), has to say about IPOs:
“An elementary requirement for the intelligent investor is an ability to resist the blandishments of salesmen offering new common stock issues during bull markets. Even if one or two can be found that pass the test, it is probably bad policy to get mixed up in this sort of business. Of course the salesman will point to many such issues which have had good-sized market advances—including some that go up spectacularly the very day they are sold. But this is part of the speculative atmosphere. It is easy money. For every dollar you make in this way you will be lucky if you end up by losing only two.
…The heedlessness of the public and the willingness of selling organisations to sell whatever may be profitably sold can have only one result – price collapse. Many new issues lose 75% and more of their offering price…Some of these issues may prove excellent buys – a few years later, when nobody wants them and they can be had at a small fraction of their true worth”.[viii]
As ever in investing, the best advice is timeless!
[i] “The Long-Run Performance of Initial Public Offerings,” March 1991, The Journal of Finance, Jay R. Ritter. [ii] “Why new issues are lousy investments” 1985, Forbes Magazine, Richard Stern and Nigel Bornstein. [iii] Reported in Ch. 6 of The Future for Investors: Why the tried and true triumph over the bold and new, Jeremy Siegel, Crown Business, 2005. [iv] Tread Carefully in a Hot IPO Market | Kiplinger [v] Huang, J. University of Birmingham, 2011, ‘Long-term Performance of UK IPOs’ 1982-2004 [vi] Myth or Reality? The Long Run Underperformance of Initial Public Offerings: Evidence from Venture and Nonventure Capital-Backed Firms,” December 1997, Journal of Finance, Alon Brav and Paul A. Gompers.
“The long run performance of initial public offerings: The UK experience 1980-88,” 1993, Financial Management, Mario Levis.
Huang, J. University of Birmingham, 2011, ‘Long-term Performance of UK IPOs’ 1982-2004[vii] e.g. “The Long-Run Performance of Initial Public Offerings,” March 1991, The Journal of Finance, Jay R. Ritter.
“The New Issues Puzzle,” March 1995, The Journal of Finance, Tim Loughran and Jay R. Ritter.
“The Equity Share in New Issues and Aggregate Stock Returns,” 2000, The Journal of Finance, Malcolm Baker and Jeffrey Wurgler.[viii] Chapter 6 (“New Issues”) of The Intelligent Investor: A Book of Practical Counsel, Benjamin Graham, Harper & Row, 1973.