What you need to know before you invest in IPO’s

I have not seen this type of brand name IPO trading volume for quite some time. From Groupon (GRPN) and Pandora (P) to Zynga (ZAGG) and now Avaya, the media would have you believe that investing in a brand name IPO is a quick fix for your portfolio.

Take the recent public stock offering in LinkedIn (LNKD) for example. The IPO price was set at $45 and jumped to $90 after one day of trading. As of this writing, the price is just below $73. At its current valuation, Morningstar estimates the Price-to-Earnings (P/E) ratio at 466. By comparison, the tech-heavy NASDAQ has a P/E of less than 20 (as of this writing).

Clearly, many people are very excited about the LinkedIn IPO and it shouldn’t surprise you that investors have had a long history of enthusiasm for IPO stocks. But has this enthusiasm ever paid off over the long-term? To answer this question, you first must do the research.

Do the Due Diligence

There is also a substantial body of research that examines how and why IPO stocks perform the way they do. There are two major themes that emerge from this research:

1) Stocks generally see their prices skyrocket on their first day of trading, which would seem to imply that these stocks are under-priced when they are introduced.

2) The long-run returns of IPO stocks are not particularly attractive, on average.

It is important for investors to understand both of these underlying effects because they are persistent in studies covering more than 6,000 IPOs over a 40-year period.

The exuberance associated with an IPO is not new. The study linked in item (1) finds that IPO stocks have averaged a 19% gain on the first day of trading, going back to the 1960’s. From 1980 to 2009, the average first-day gain for a sample of 7,354 stocks is 18%.

There are many theories surrounding why IPOs exhibit such a huge run-up on their first day. Consistent price gains like these would suggest that IPOs are consistently under-priced when they are brought to market. Regardless of the mechanism, however, it is little wonder than investors clamor for stocks that have just gone public—the prospect of an average gain of 18% in a single day will attract any speculator!

But what about an IPO’s long-term performance?

Poor Long-Term Performance

In principal, we would expect a strategy that invests solely in IPOs to behave similarly to portfolios made up of small cap growth stocks, because IPOs usually fall into this category. Indeed, research into IPO performance confirms this effect.

When standard factors known to impact performance are taken into account (small cap vs. large cap, value vs. growth), IPO stocks show a tendency to substantially under-perform over a three-five year period after going public. Dr. Jay Ritter at the University of Florida regularly updates his research on this effect. In his most recent results (published in June 2011), the average three-year return of IPO stocks lagged the average three-year returns of similar non-IPO stocks by 7.2%.

How can we reconcile the apparent under-pricing when issued, with the huge initial run-up in price and then subsequent under-performance over three to five years? Dr. Ritter has concluded that these effects are simply a result of fads and irrational optimism on the part of investors.

I agree.

In my own study of IPO performance, I have concluded that it is undeniable that the huge run-ups in first day of trading suggest major speculative activity. The poor long-term performance of IPOs (as a group) support this conclusion.

Don’t Buy into the Hype

IPOs attract so many market speculators that their valuations are driven well above a rational estimate of fair value. The fact that some stocks live up to these astronomical valuations (while the group as a whole) under-performs on average, is consistent with investors who love taking risk. These investors are willing to throw the dice and risk poor returns just to have a chance at a high return. This behavior does not, however, mean that IPO investors are irrational. It just means that they can stomach the over-valued market fluctuations.

The implications of the research into IPOs should not be terribly surprising. Investing in IPOs is a high risk, speculative activity, that may provide a chance of phenomenal returns.

Is it for everyone? No.

This type of high risk-high return trading activity is available in a range of other ways—notably by buying options. For those investors who gamble in buying IPO stocks, I simply hope that they are aware of the historic long-term lackluster performance of IPOs and take their positions from a fully informed standpoint—and not by listening to the media hype.

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6 thoughts on “What you need to know before you invest in IPO’s

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