Not since the Internet boom of the late 1990s have IPOs been generating the level of interest and buzz as the current crop of recent and upcoming IPOs.
Several unicorns (i.e. private startup companies with valuations greater than $1 billion) have recently made their debut on the public markets in 2019, including Uber, Lyft, Zoom Video Communications, Pinterest and Beyond Meat. AirBnb, Slack and WeWork are rumored to be right around the corner.
An IPO is when a company that is privately held first offers shares to public investors. It’s a way for companies to raise capital and for early investors in the startup to offload their shares. Underwriters (i.e. investment banks) purchase the shares of the company being sold in the IPO and then re-sell them to public shareholders, and the issuing company becomes a public company.
IPOs are particularly popular when the stock market is at all-time highs, like it is right now. Companies going public want to capitalize on favorable market conditions. Overall high valuations in the stock market give companies going public the best ability to raise as much money as possible while giving away as little ownership as possible.
There is a difference between holding pre-IPO shares in a company and trading in the stock of a company after it has gone public. If you want to invest in a pre-IPO company, that typically only happens if you’re an employee of the company and receive equity as a part of your compensation or if you’re an institution, such as a venture capital fund, that has negotiated an equity stake in the pre-IPO company in exchange for prior financing.
This post is about trading or investing in the stock of a company that has already gone public. While IPOs generate a lot of excitement, it’s generally a bad idea for retail investors like you and me to invest in stocks of companies that have just gone public. You already know that I’m not a fan of trading individual stocks, but trading in stocks of companies that have just gone public introduce their own special types of risks.
An Anecdote – Palm Pilot
Do you remember the Palm Pilot? Anyone in their early 30s and younger probably don’t.
In the mid to late 1990s, a company called Palm introduced a device called the Palm Pilot. Palm Pilots were the precursors to the modern smartphone and allowed users to keep a digital rolodex, calendar, to-do list and notes all in one magical device. Sounds quaint now, but these were iPhones before the iPhone, and anyone who was someone had one.
On March 1, 2000, Palm stock was offered to the public for the first time in an initial public offering. These were still the earlier days of online trading, and I woke up early ready to get in on the action.
Shortly after the company’s shares started trading on NASDAQ, some of my friends and fellow Palm Pilot fanboys bought some shares. I watched mesmerized as the share price ticked up and down every second, but I never pulled the trigger. Investing in stocks seemed too risky, though I was certain that I’d end up regretting my decision as my other friends got rich. However, it turns out I got lucky.
Palm, Inc. shares opened trading in the $90s and got as high as $95.06. Then, the Internet Bubble burst. Dot-coms went out of business. In less than a year and a half, Palm stock lost more than 90% of its value. Palm was eventually acquired by HP.
So, you’re probably wondering – does one anecdote about a company that made a product that went obsolete really mean that you and I shouldn’t invest in stocks of companies that just went IPO?
No, but it’s just a story about how real FOMO – fear of missing out and how it can be easy to get caught in can’t-miss IPO fever. Everyone wants to get in on the action. Everyone hears about employees
However, let’s look at some of the other reasons why investing in new IPO stocks is generally a bad idea.
Reasons Why Investing In IPOs Doesn’t Work Out
Historically, investing in stocks right after an IPO has generated sub-optimal, market-lagging returns.
- From 1980 – 2016, companies that IPO’d have underperformed in stock performance relative to other companies of the same size by 3.2% per year for the first five years after IPO (see Jay Ritter, Initial Public Offerings: Updated Statistics on Long-Run Performance). On a $100K investment, that’s $17K of underperformance over a 5-year period.
- Additional research has shown that most IPOs are losers. Data collected by Jeremy Siegel, a professor at UPenn’s Wharton School of Finance, in his book Stocks for the Long Run show that 79% of IPOs underperform compared to a representative small stock index. IPOs underperformed the Russell 2000 (an index of small company stocks) in 29 of 33 years, calculated both at the IPO price (before the customary first day pop) and after 1 month of trading.
A company with the world’s hottest product does not mean that its stock will automatically go up when the stock of the company making the product goes public. Everyone else is already aware of the product.
Buying stock of newly-IPO’d companies is a lot like buying a lottery ticket. There’s excitement about a big potential payday. If you want that rush, just go gamble.
Many companies going IPO aren’t profitable, and in fact, many lose money hand over fist. Lyft lost $1.1 billion in just the first quarter of 2019.
The valuations of these companies are speculative – they’re relying on rapid growth that will eventually allow for the company to become profitable.
For every Amazon or Apple that has become extremely successful stocks since their IPOs, there are many more that haven’t. Remember Pets.com or Palm from the Internet boom? Or, Blue Apron, the meal kit company, whose stock since its IPO in the past year and a half has dropped 90%?
By buying a single stock, you’re taking on idiosyncratic risk. What if the brilliant founder CEO engaged in conduct that forces him out of the company? What if the business doesn’t grow as quickly as eager investors like you expect?
IPOs are seductive. You hear about employees and early pre-IPO investors getting rich and hitting it big with the IPO. There’s a natural tendency to want to get in on the action. However, keep in mind, when you invest in the IPO shares, you’re the money cashing out the employees and early investors who are getting rich. By the time you get in, the big game is already over.
Lots of IPO investors are clueless and can’t even get the basics correct. A recent NY Times article shows that publicly traded companies with names similar to companies who go IPO see their stock prices go up as part of the anticipation of the pending IPO (of a totally different company)!
For example, Zoom Video Communications filed an S-1 registration statement in March 2019, publicly announcing an intention to go public and then had their IPO on April 18, 2019. During that same period, a barely-traded penny stock named Zoom Technologies saw its stock price rise 27,000%. If you bought stock in Zoom Technologies thinking you were buying shares of Zoom Video Communications, oops.
Another funny example from the article centers around Twitter. A similarly named, but totally unrelated company, Tweeter Home Entertainment, saw its shares rise 1,800% in the buzz leading to Twitter’s IPO. Snap Interactive’s stock price rose as much as 120% in the lead-up to Snap (maker of SnapChat) and its IPO.
In all these cases, people mistakenly purchased their shares. Maybe what this means is that there’s money to be made by buying shares of companies whose names are similar to those companies who are rumored to potentially be going public and waiting for the ding-dongs to start buying (don’t actually do that). They buy the stocks of the wrong company and end up driving up the stock price of a totally unrelated company.
