This year, you had to be living under a rock if you didn’t hear about social media company Snap’s (SNAP) stock market debut. When the company held its initial public offering (or IPO) on March 1, 2017, it raked in $3.4 billion. This made Snap one of the tech industry’s biggest IPOs — ever.
Very early-in investors could have made millions of dollars from Snap’s IPO. But are IPOs worth your time and money?
IPOs Are Simply too Risky
An initial public offering is the first sale of shares on the stock market by a formerly private company. It’s when a company “goes public.” But investing in an IPO can be like playing a video game — you need to hit the right button at just the right moment.
And unfortunately for most of us, the right moment is before the actual IPO takes place. A company’s founders and private equity investors have the chance to make some of the biggest gains from an IPO. That’s because, within the first few minutes of trading, a stock can spike by 20% to 50% — or more. That means, even if you placed a buy order before the market opens, you’ll still be getting in at a higher price.
The five top-performing IPOs of 2016 gained between 99% and 193% by year’s end, some in a matter of weeks or months. Those headlines can lure investors into thinking an IPO is a sure-fire profit opportunity… until you consider that the worst-performing IPO companies from 2016 lost between 52% and 85% of their value over the same time period.
(A stock’s price can drop for any number of reasons. I’ve written about some of these causes — and how to profit from them — in this Investor Junkie article. And if you’d like to read more about undervalued stocks, check out this essay.)
Therefore, getting in on an IPO can be just too risky for most investors who can invest in a stock only after it goes public. The company’s founders and early-in investors get the liquidity and huge gains, and most of their wealth is less sensitive to these public market variations. After all, if you bought a stock when it was valued at 5 cents, you are less sensitive to the difference between $17 and $26.
Why It’s Better to Wait
A better time to get into a stock can be a few weeks or even months after a company has held its IPO.
For example, Facebook’s (FB) initial public offering in 2012 was priced at $38 per share. But when trading started, the price went straight down.
Six months later, investors who were “lucky” enough to get in at the offering price had lost half of their money. It took 15 months for the share price to recover. Not such a hot investment… except for those who bought in after the IPO, when Facebook was priced below $20 per share. Since this stock is now worth more than $140, investors who timed it right have made seven times their money.
Taking a look at Snap, the company went public at a price of $17 per share, but it opened at around $26. That’s when those early-in investors made millions. But then Snap headed down and, as I write, is currently priced around $20.
Will Snap repeat Facebook’s price pattern? Who knows.
With any stock investment, you need to understand the fundamentals of the company’s business. An IPO adds the wild-card factors of the somewhat arbitrary offering price, the volatility of the opening minutes of trading and the effects of those first-day price changes. If you are a long-term investor and believe the company has fundamental value — think Google (GOOGL), Amazon (AMZN) or Facebook — then the early volatility and the risk of price drops are of less concern.
But for most of us, IPO investing is just too risky.
Currently, there’s an added challenge to IPO investing. Simply put, the IPO calendar is relatively empty. This has resulted in investors and investment dollars chasing fewer opportunities, adding to the volatility. More companies are choosing to be acquired by another company rather than becoming an independent public company. Others, like Uber, are choosing to stay private much longer than they could, partly due to the variety of investors they have attracted.
Editor’s note: Fred’s next article will discuss why the IPO calendar is so empty and how investors can view this as a potential opportunity. Stay tuned…