IPO Investment: Should You Invest in an IPO?

IPOs might sound exciting, but does that mean you should invest in them?

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IPO investment (Initial Public Offerings) have an exciting, almost exotic ring to them. They conjure up visions of large, sophisticated investors with an inside track making millions on a single stock transaction. For better or worse, that's more the “TV version” of IPOs than the reality. True, some IPOs succeed in creating overnight millionaires. But it's likely most of those investors were already close to becoming millionaires before the IPO.

For the average investor, IPOs may prove to be only a little bit more profitable than ordinary stock investing. Maybe you'll make a lot of money on a single trade, and maybe you won't.

But is an IPO Investment worth your time and money?

What Is an IPO?

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.” Investing in an IPO is a lot 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 usually make some of the most significant 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.

See Also: What Are SPACs?

How Do I Invest in an IPO?

You'll need to work with an investment brokerage firm that handles IPO transactions. Not all do, so you shouldn't assume the broker where you currently trade offers them.

E*TRADE and TD Ameritrade, are some of the brokers we like that offer IPOs.

  • You'll need to have your account up and running before the IPO hits the market.
  • Because IPOs are somewhat more complicated than trading existing stocks, you'll want to be sure your account is in place, and you're familiar with the process of purchasing IPOs. We highly recommend a phone chat with a representative of the brokerage firm.
  • It's also important to understand that it's unlikely you'll get the initial offering price on the stock. That price will go to the very first investors who get in on the IPO. But once the trading starts, price action can get wild. The price may go higher or lower, and dramatically so in either case.
  • Should the stock begin running up immediately out of the gate, you may pay $60 for a stock that opened at $40 — on the very same day.

What could've been an excellent investment at $40 may not be so attractive at $60. You can protect yourself by setting a limit order at, say, $45. That way, you don't get caught chasing the stock up to an unrealistic price level.

Where Can I Find Out About Upcoming IPOs?

You can find out about upcoming IPOs from various publicly available sources.

  1. MarketWatch offers an IPO Calendar that shows recently priced IPOs, upcoming IPOs, future IPOs, and withdrawn IPOs. The list includes the name of the company, the proposed symbol, the exchange it will be listed on, the price range, number of shares, and the week when the IPO will take place.
  2. Another source is Nasdaq's IPO Calendar. Even though Nasdaq publishes it, it also shows IPOs coming up on the New York Stock Exchange. It provides much of the same information as the MarketWatch IPO Calendar, but it's not quite as well organized.

Be careful in getting caught up in rumors of IPOs. They abound, but they're mostly media speculation. Often, it's an analyst citing the benefit of a particular company going public. The media then picks up the story, and inertia takes it from there.

Rumors of IPOs are not the same thing as IPOs. Even if a company indicates an interest in going public, it can take many months before the deal is finalized. Investment bankers need to estimate the company's value before determining a price per share and the number of shares that will be offered. The company then files paperwork with the Securities and Exchange Commission (SEC). This starts a back-and-forth process that can take months to complete.

Do Your Homework Before You Invest in IPOs

A lot of hype surrounds many IPOs, and that's exactly what you need to avoid. The hype is nothing more than speculation about miracle moneymaking activities that have no place in reality.

Remember that those companies looking to go public are still in some phase of early growth. While that growth might be rapid early on — often due to the lack of competition — they can easily run into unexpected headwinds following the IPO. What looked like a can't-miss opportunity could quickly turn into a financial disaster.

Make sure you perform due diligence on any company you're considering investing in. The fact that it's an IPO makes it no different from any other company you would consider buying.

Information leading up to IPOs can be notoriously scarce precisely because the company is private. But the company will issue a preliminary prospectus, sometimes referred to as a “red herring.” The issuer and lead underwriter provide the prospectus. It includes the typical information available on a publicly-traded company.

You should also view any IPO with a healthy respect for reality. No matter how promising a company may look on paper or by presentation in the media, its stock can still crash and burn following the IPO for reasons no one anticipated before the fact.

Why Do Companies File IPOs?

A privately-owned company can grow only so big before capital for continued growth becomes scarce. For example, their main capital sources during the early growth phase may be venture capital or even bank loans. But there's a limit to how much money can be accessed through those sources. What's more, bank loans require loan payments. And venture capitalists expect a certain return on their money.

It's just a question of time before a fast-growing company needs to consider going public to obtain the capital they need. By going public, the company avoids the debt obligation that comes with bank financing and the control factors that may be imposed by venture capitalists.

This is the basic reason companies go public. Virtually every one of the companies listed on public exchanges had to make that transition at some point. The ability to raise capital through the sale of stock is the reason so many companies have gotten as large as they are.

Historical Returns of IPOs

The screenshot below, created by iPreo, shows the performance of IPOs versus the S&P 500 between 2009 and 2018.

IPO Performance 2009–2018
IPO Performance 2009–2018 (from Fidelity website)

IPOs easily outperformed the general market in some years. But other years, they underperformed it. For example, in 2018, when the S&P 500 turned in a gain of nearly 30%, IPOs provided only 5%, and in 2015, a year in which the general market was flat, IPOs showed a loss of 9%.

In a real way, what the screenshot shows looks eerily similar to the performance of an individual stock against the general market.

That may be the ultimate reality of IPOs.

If you can subtract all the hype and focus on what's really going on (or what has happened in the past), it may prove to be no more profitable than other stocks.

Risks of Investing in an IPO

Before even considering investing in an IPO, you should be aware that they don't always have a happy ending. One celebrated recent example is Uber.

The stock went public in May 2019, at $41.57 per share. It climbed as high as $46.38 on June 28 but then began to struggle. It reached a low of $21.33 on March 20, 2020, then recovered. As of July 27, 2020, the price is $30.99.

Had you pounced on Uber when it opened, you'd be sitting on a loss of approximately 25% over a space of just 14 months. And that even includes the general stock market rebound that's taken place since late March.

If you want to invest in IPOs, be sure to learn all you can about the company before it goes public. The fact that it's going public doesn't give it value, but it's very easy to get caught up in that misguided belief.

You should also avoid the temptation to get caught up in the excitement of the moment. IPOs can be overrated — if a company is a good investment, it'll be a good investment well after the IPO. In fact, it may even be better to wait until after the IPO, when the price of the stock stabilizes or even drops as the excitement dies down.

Also, make sure you don't get carried away with IPO investments. Limit participation to no more than 10% of your portfolio. That way, if the IPO goes against you, the loss won't be catastrophic.

IPO Investment is Risky, So Do Your Research

With any stock investment, you need to understand the fundamentals of the company's business. An IPO Investment adds the wildcard 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 (FB) — then the early volatility and the risk of price drops are of less concern.

But for most of us, an IPO investment is just too risky.

And there's currently 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 are choosing to stay private much longer than they could, partly due to the variety of investors they have attracted.

Fred Whittlesey

Impact investor, compensation consultant, compensation expert witness, university professor, writer, and rock guitarist. His blogs include Effective Equity. You can follow Fred on: Twitter - LinkedIn - Google+

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