Initial Public Offerings (IPO). Cutting Through The Noise

Initial Public Offerings (IPOs)

Initial public offerings (IPOs) can draw a tremendous amount of attention from the investing public. Many involve companies and brands we’ve grown accustomed to as we use and trust their products in our daily lives. This is particularly true in 2019 with names such as Uber, Lyft, Beyond Meat, Pinterest, Zoom or other “Unicorns” deciding to go public. Below we’ll discuss some IPO basics before diving into what the historical performance data suggests as well as some challenges that investors may face when investing in IPOs.

IPO 101

An IPO - in it’s simplest form - is when a previously private company first becomes publicly traded. This is often referred to as “going public”. There are several ways a company can achieve this, but the most common way is through the involvement of one or more investment banks and the ultimate listing of the stock on a publicly traded exchange - such as the New York Stock Exchange or NASDAQ.

Why “go public”? Being on a publicly traded exchange allows a wider range of investors to more easily and regularly exchange capital than if the stock were privately held. This ease of transaction is appealing for companies as it allows them to enjoy a new source of capital to fund operations, service debt and (presumably) grow. For a well run company, the benefits of accessing new capital typically outweigh the increased compliance and reporting obligations that come with being a public company.

In the United States a company starts the process of “going public” by notifying the investing public of their intention by filing a Form S-1 with the Securities and Exchange Commission (SEC). This form discloses key information that previously may not have been shared with the investing public and is often the first real glimpse into the financial health of a company anticipating an IPO. An S-1 is unlikely to have every last detail included with regards to the company’s ultimate IPO price (for inside/preferred investors) or date of IPO, but it does at a minimum serve to notify the investing public of the company’s near-term intentions for it’s stock. To many investors this is an exciting event as it is providing notice that they will be able to acquire an ownership stake in a company they previously could not access.

IPO Performance - The Facts

So how have IPOs stacked up? Research from Dimensional Fund Advisors (DFA) explains “as a group, they (recently IPO’d companies) have behaved like small growth, low profitability, high investment stocks. As such, they have underperformed the broad US market in their first year” (Black and Green, 2019). Per DFA’s research however, initial trading enjoyed an average first-day return of 17.9% from 1980 to 2018. A crucial fact to consider is that while IPO performance may reflect irregularly large stock returns on the first day shares become available, not all investors enjoy the same upside on this first day. In fact, most of the investing public does not enjoy the same average first-day performance referenced above. This is because select “inside” investors receive separate initial pricing opportunities or access than the rest of the investing retail public. Those with this preferred access through the underwriting investment banks or other inside access are likely to capture more of the average initial trading performance referenced above than the investing public.

Based on Stanley Black, PhD and Kevin Green, PHD’s research for DFA, after the underwriting investment bank’s initial trading, prices are more likely to fall as less of those large flows of capital are being provided which may then result in downward stock pressure (as less buying exists). At the same time however, many of those insiders who benefited from preferred access often must hold their positions for a set period of time before selling. These “lockup” periods can last six or twelve months, so despite strong initial performance, those gains are not necessarily assured for many more months. This can cause further price volatility once the lock-ups expire.

How do IPOs perform in the secondary market during their first year, beyond the initial trading day? Black and Green continue by reporting that while no two IPOs are the same “one potential performance headwind for IPOs is the expiration of lockup agreements. Generally, a large percentage (typically 50% or more) of the IPO shares held by insiders are subject to lockup provisions that prevent such insiders from selling shares on the open market. When the lockup agreements expire, usually 6 to 12 months after the initial offering, these shares may be sold in the marketplace, creating a liquidation event that puts downward pressure on the stock price.”

Conceptually, this makes sense considering that many of the “insiders” that have had their capital locked up may have a substantial portion of their personal wealth at stake. If the company’s stock has been particularly successful during the lockup period, some insiders may be even more inclined to sell high at the first opportunity to realize gains and reduce overall risk. Even if the stock price has not performed well, insiders may feel pressure to sell at the earliest opportunities. With enough market participants looking to sell, the stock price is more likely to decline absent eager buyers. Market participants looking to be involved with recently IPO companies should understand this risk well before engaging in IPOs during a company’s first year on a public exchange.

Further, per DFA, overall “Most IPOs fall into the small cap size group, defined as firms that fall below the largest 1,000 US-domiciled common stocks at the most recent month-end. Large cap and mid cap IPOs represent 24% and 19%, respectively, of total capital raised through IPOs”. Green and Black analyzed that from 1992 to 2018 IPOs still underperformed the Russell 3000 Index (a market-cap weighted index reflecting entire US stock market performance). During this period, IPOs generated an annualized compound return of 6.93% overall, as compared to 9.13% for the Russell 3000 Index. In comparison to the Russell 2000 Index (index measuring 2,000 of the smallest US public companies), IPOs underperformed in the overall period from 1992 to 2018 (6.93% vs. 9.02%). IPO returns also exhibited higher levels of volatility relative to the Russell 3000 and 2000 indices despite providing lower returns in many cases (Black and Green, 2019).

What to make of an IPO?

Individual investors should be aware of the risks involved with newly public company investing. Given the variables at play there is potential that pressures from large investing parties such as underwriters that offer pricing support or key employees with lockups can dictate much of the trading and pricing activity in the first 6 to 12 months. For a retail investor the allure of getting in at the ground floor of a newly listed company is tempting. We encourage folks to think-twice and resist the temptation. Do your research first. A company that has just gone public is typically associated with increased initial volatility for the first days, weeks, months and in some cases years as we have touched on above. It can take some time for the market to calibrate the stock price to it’s true fair market value.

If you aren’t prepared to withstand some near-term pain and uncertain long-term results - diving into an IPO may not be for you. Initial prices may swing wildly and can test the nerve of even the most seasoned investor. What was believed to be a fair price by the investment bankers or analysts during the pre-IPO/listing process has no obligation to come to fruition how and when you’d like. Prices are dictated by many different market participants in reality. While we often hear the success stories of companies that go public, we rarely hear of the common stories of IPO companies that do not enjoy tremendous price growth in the first days and weeks of being listed on a public exchange. Patience, persistence and reliance on fundamental analysis can be key to deriving long-term value from a promising company’s IPO. For weeks at a time a company that looked so good previously may inexplicably slump. Human emotion and investor sentiment may drive behavior and price may deviate from it’s true value. Our belief is that investors are more rational in the long-term, however in the short-term bubbles and panics can occur leading to these unjustified deviations in valuation.

While there are many success stories of companies that IPO, they are not necessarily the norm. Even well known companies such as Facebook (FB) took well over a year to recover it’s IPO price after first being listed. In the end, it is important to do your own research and understand the risks involved with investing into a newly public company. The truth is no one knows for sure what the future holds. Some companies with stronger fundamentals, a track-record of the ability to produce a recurring profit (which seems increasingly rare in newly IPO’d companies), and other promising key metrics are a better bet than those without. Even then, the historical performance data as referenced above suggests that IPOs have been nothing near a sure thing for most investors when compared to the rest of the market. We often only hear of the success stories from big brands and hindsight is of course 20/20. From an insider’s perspective there may be more certain opportunities to take advantage of, for the rest of the investing public - buyer beware.

Whether you work at a company that has recently undergone an IPO, is shortly anticipating an IPO, or are simply an individual investor looking to better understand the risks of newly IPO’d companies or markets in general - we would be happy to have a conversation. Feel free to contact us to learn more.

Black, Stanley & Kevin Green. 2019. “What to Know About an IPO”. Dimensional Fund Advisors: Research Matters. 1-6.

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