Tech Brands Hit the Public Markets via "IPO" but Should You Be Investing in Them?
This article previously appeared on GritDaily.com. Grit Daily provides news coverage on brands, fashion, tech, influencers, entrepreneurship, and life.
So far this year, 107 companies have gone public in the United States through an initial public offering (IPO).
At the time they went public, those companies employed nearly 119,000 people, many of whom became millionaires and decamillionaires in the process. This rush to instant wealth is probably the most attention-grabbing aspect of IPOs, and seeing the media buzz may lead us to wonder whether they can help us get rich ourselves. So, can some of that wealth rub off on your early retirement fund? Setting aside the hype, let’s look at what the data tells us.
What exactly is an IPO?
Simply put, it’s one of the ways companies can raise the investment capital they need to fund growth throughout their lifecycle. Once a company becomes large enough to list its shares on a public stock exchange and generate sufficient interest from potential institutional and individual investors, it can register its shares with the US Securities and Exchange Commission and offer its shares to the public. That process is known as an IPO.
How have IPOs performed?
Some of the most media-hyped firms going public in 2019 have had mixed results so far. As of July 19, 2019, investment returns post-IPO for widely touted IPOs included: Levi Strauss -15.0%, Lyft -22.3%, Uber +2.8%, Pinterest +19.4%, and Zoom Video Communications +54.5%. WeWork, reportedly valued near $50 billion, is slated for an IPO in September.
News reports often tell a more simplistic story by citing the first day investment return for an IPO. For example, Lyft priced its IPO at $72 per share, and once the stock began trading on March 29, 2019, its price shot up briefly to $87 per share, gaining over 20%. The stock price then fell and finished the first day of trading at $78, a one day gain of 8%. Most investors would be happy with a 20% gain, or having failed to sell at the high, an 8% gain at the end of the day.
The trouble is, most individual investors are not able to buy shares in IPO companies at the offering price. Those shares are reserved for preferred customers of the securities firms managing and participating in the IPO. Most investors are only able to buy IPO shares in the open market once shares begin trading. In the case of Lyft, most investors buying in the secondary market lost money that first day because they bought at a price above the closing price of $78 per share and not at the offering price of $72 per share.
While first-day returns average 18% for IPOs, these returns are usually minimal for investors buying in the open market, since they can’t buy stock at the offering price.
Because the large average first-day returns are typically not realizable by most investors, they’re excluded by analysts when computing IPO investment returns—making analyst data a much more useful source of information than what is usually reported through the news.
Performance data from Renaissance Capital, a leading source of information about IPOs, for periods ending July 31, 2019, show that IPOs (as measured by its Renaissance IPO Index) are up 40.2% for the year compared to 20.2% for the S&P 500 Index, which tracks the performance of the 500 largest stocks in the US.
Three-year investment returns for the IPO Index of 17.8% per year also beat the S&P 500 Index at 13.4% per year. However, the five-year and inception-to-date (about ten-years) investment returns for the IPO Index trailed the S&P 500 Index at 9.1% and 14.2% compared to 11.3% and 14.7%, respectively. While IPO investment returns are beating the market by a factor of two so far this year, IPO investment returns over other time periods are mixed.
In a recent white paper from Dimensional Fund Advisors titled “What to Know About an IPO,” the authors studied IPOs from 1992 to 2018. Looking at one-year investment returns (excluding first day returns), they found a portfolio of IPO stocks underperformed the Russell 2000 and Russell 3000 indices, which represent US small stocks and the entire US stock market, respectively. (Most IPOs are small companies, which make the Russell 2000 Index a good comparison.) IPOs earned an annual investment return of 6.9% compared to 9.0% for the Russell 2000 and 9.1% for the Russell 3000. In general, IPOs in their first year earned about 2% less than the overall stock market during this 27-year time period. IPOs were also more volatile than the overall stock market, as measured by the Russell indices.
While IPO performance isn’t bad in an absolute sense and in fact has been good so far this year, returns over time have been mixed and on average lagged comparable companies in recent decades. The likely reality is, unless you are able to buy IPOs at the initial offering price (i.e., receive an “allocation” of IPO shares from your broker), investing in IPOs isn’t going to build your wealth more quickly or dramatically than investing in similarly sized companies or the market as a whole.
IPOs do have a place—nestled in among other stocks, usually in the well-diversified small cap portion of a portfolio. But despite our cultural fascination with IPOs and the millionaires they create, for most of us they aren’t quite the glamorous opportunities we may imagine and not the best investments to emphasize.