Who wouldn’t want to be an early investor in a company that’s destined for greatness? In hindsight, plenty of people regret missing the initial public offering of Apple Inc. (ticker: AAPL) in 1980, Microsoft Corp. (MSFT) in 1986 or Google Inc. (GOOGL, GOOG) in 2004.
But no one regrets missing duds like Pets.com, which had a spectacular rise and fall from its IPO in February 2000 to its liquidation less than a year later.
Most initial public offerings occur without much fanfare. The ones that generate excitement outside Wall Street tend to be large offerings from well-known companies.
Facebook’s May 2012 IPO was a magnet for investors hoping for a ticket to a rocket ride. The offering itself was marred by technical difficulties on the Nasdaq stock exchange, and it was more than a year before the stock finally regained its opening-day high price of $38.23. Now it’s trading at more than $90 per share, and has gone up nearly 30 percent in the last 12 months.
Although Facebook’s stock price eventually took off, the IPO shed light on difficulties for individual investors trying to get a piece of the pie. In general, the majority of shares are reserved for large institutions, which are able to buy at lower prices.
“Typically, if a broker is about to give you an IPO before it actually hits the market, I would just avoid that IPO. They’re not giving you a gift,” says Gennady Kupershteyn, managing partner of Kupershteyn Advisory Group in Washington Township, New Jersey. Kupershteyn manages his own money, advises brokers and traders, and publishes market updates through his CapitalistBull.com newsletter.
A company issues public shares to finance growth. It hires an investment bank or broker-dealer to underwrite the IPO. The underwriter purchases the shares and resells them to other institutions. The world of high finance is fairly cozy, so institutions getting a big chunk of initial shares tend to be those doing significant business with the underwriter.
If a brokerage firm believes an IPO has staying power beyond its initial price pop in the first few hours of trading, shares will go to the firm’s larger clients, Kupershteyn says. That makes it tough for the small investor to get in early, particularly when the deal has high institutional demand.
“They’re not going to give those shares to the general public,” he says.
High demand for an IPO doesn’t always mean the stock will be a winner. Jay Ritter, a finance professor at the University of Florida, researched performance of IPOs relative to other stocks with similar market capitalizations. He found that IPOs underperformed by an average of 3.3 percent per year in the five years after issuing, not including first day, when there is often a large price spike. The price often drops after that first day as large institutions take profits. Sometimes prices remain low for an extended period.
“Anyone who tells you that they know the long-term prognosis for any specific company would only be guessing. We’ve found that IPOs are often extremely risky and expensive for investors,” says Zack Shepard, vice president at Matson Money in Scottsdale, Arizona.
Referring to Ritter’s research, Shepard points out that after two years, the average IPO underperforms stocks with similar characteristics by more than 5 percent. “Another way to think about this is: If you are trying to find the next Google, you risk finding the next Pets.com,” he says.
Bill Militello, CEO of Militello Capital, a Leesburg, Virginia, private equity firm specializing in technology and real estate, says individual investors should remember that someone is on the other side of their IPO trades.
One problem arises with the expiration of the insiders’ lock-up period. Employees, venture capitalists and founders are often prohibited from selling shares before a company’s IPO, and for several months afterward. This is to prevent a deluge of shares from hitting the market shortly after the public offering.
But even after share prices settle down after an initial pop, investors would be wise to wait longer, Militello says.
“Investing at the time of the IPO is the point of greatest risk and least reward because the shares are being liquidated, pushing down the price. The company’s original investors, its founders and employees, are liquidating their positions when the initial lock-up period is over. Why would you want to buy at the highest price? There is no more incentive to grow the business as early investors cash out,” Militello says.
As a private equity specialist, Militello has a different perspective on the IPO market than brokers who may be encouraging clients to speculate with a newly public stock. “The IPO is put into place when insiders believe the public markets will buy the stock at a much higher valuation than what private-equity investors will pay,” he says.
He cites the “greater fool” theory, in which a seller determines an offer price not according to intrinsic value, but according to what the market will bear. “Remember that a company’s IPO is another investor’s exit strategy,” Militello says.
As a proponent of efficient markets and diversified portfolios, Shepard advises against betting on any individual stock, whether of a new or established company.
“Markets are extremely efficient and can set prices by factoring in all of the knowable and predictable information instantaneously. By letting the market settle the price, you can also subsequently determine the asset category in which a particular company should be held and by what percentage. Making a bet before the market sets the price is simply too risky and costly to attempt, as IPOs as a whole do not perform well in their infancy,” he says.
But even the investor who uses mutual funds or exchange-traded funds in a diversified portfolio sometimes wants to speculate with a small amount of money not earmarked for retirement or some other goal.
In those cases, Kupershteyn recommends that investors sit tight throughout the lock-up period and allow the company to notch some quarters of strong fundamentals.
He cites the example of Mobileye (MBLY), which makes collision-warning systems for cars and trucks. After Mobileye went public in August 2014 at $25 per share, stock prices soared as high as $56 in a month before badly slumping earlier this year. Since March, however, the stock has resumed its rally, even briefly topping $60 last month.
“Here’s a stock that you didn’t need to get into early on,” he says. “You could have allowed the story to play out, and said, ‘Hey, could they deliver two or three quarters of solid earnings?’ Once they did that, now you have a better idea that this is a stock for your portfolio, and you can put it away for the long term.”
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Should You Buy an IPO? originally appeared on usnews.com
