- IPO numbers are falling as increased market volatility makes investors cold towards to new issues.
- Upward pre-IPO price revisions bring to better initial returns.
- Recent IPO stocks get hammered at any sign of trouble in the markets.
An Initial Public Offering (IPO) is the first sale of stock by a private company to the public. An underwriting firm helps the previously private company determine an offering price and brings it to the market. IPOs can be very risky but also very rewarding; who wouldn’t hope of achieving returns similar to the ones achieved by investors who bought Microsoft Corporation (NASDAQ: MSFT) at its IPO?
Figure 1: MSFT’s returns since IPO. Source: Microsoft.
A mere investment of $1,000 would now be worth $699,000 and would currently yield almost 16 times the initial investment in dividends. But, there must be a catch to such wonderful returns, this article is going to elaborate on the risks and rewards of investing in IPOs.
IPOs vary from huge and vastly popular—like the $25 billion Alibaba IPO—to small and mostly neglected.
Figure 2: Average initial returns and issue size from sample of 13,308 IPOs. Source: New York University.
The above shows that the smaller the IPO, the higher the initial return. This is mostly related to pricing as bigger, more established companies feel like they can charge a premium while smaller companies have to offer at lower prices in order to attract capital.
The over- and under-pricing mostly determines investor returns. As companies usually revise offering prices in relation to demand for their stock, the price revision is a good indicator of initial IPO returns.
Figure 3: Average initial return in relation to offering price revision. Source: New York University.
If the offering price is revised down, the risk of overpaying is higher and vice versa for upward revisions.
Current Situation and Market Cycles
The pricing issue is also related to stock market cycles. In a bull market, companies can get more for their equity and therefore usually such periods have more IPOs.
Figure 4: Market downturns have the smallest number of IPOs. Source: Factset.
As soon as the market stopped growing in 2015, the number of IPOs fell by 40% and gross proceeds fell by 50% in relation to 2014. Initial returns are higher in bull markets as it is easier to create a positive hype around new, hot investments in a bull market than in a bear or stagnating one.
Even if a company announces an IPO, it can easily cancel it or postpone it. The most common reasons for postponing an IPO are market volatility or unfavorable market conditions. For example, in January 2016 there were no IPOs in the US and the current 2016 proceeds are 69.2% lower than in 2015 to date. The falling number of IPOs might indicate a market decline as the previous figure shows a similar pattern in 2008 and 2001.
IPOs need stable financial and political climates as companies want to get as much as possible and investors have to be willing to take risks as often IPO proceedings are used to lower the huge debt companies accumulated in order to grow. A further indication of the current market risk can be gained by a look at recent IPO deals.
Figure 5: Average monthly value of IPO deals. Source: Wall Street Journal.
It is unlikely that IPOs will pick up this year, as in June there are already potentially high impact market moving events like the UK Brexit vote and the FED meeting, only to finish the year with presidential elections in the US.
A Closer Look
In the last 12 months health care IPOs were the most popular followed by IT and Financials.
Figure 6: IPO’s by segment. Source: Renaissance Capital.
As the population ages and baby boomers need more health care, companies in the sector need more capital. IPO returns are not correlated to a specific sector and are mostly related to the quality of the individual company.
Figure 7: Top and worst IPO performers in last 12 months. Source: Renaissance Capital.
Prior to an IPO, investors must rely on only a few years of financial statements, no conference calls and an optimistic prospectus that should objectively present the company and its plans. The above figure shows how difficult it is to properly valuate companies before the IPO as the individual stock volatility after IPOs is huge.
The best performer in the last 12 months was Duluth Holdings (NASDAQ: DLTH) which went public in December 2015 and is already up 88.5%, while the worst performer is Chiasma (NASDAQ: CHMA) that is down 83.4% from the IPO price and 92% lower than its 52-week high. High volatility puts off investors on one side, while on the other companies are not interested in issuing equity when they cannot achieve a good price for it, thus the low number in new IPOs.
Interesting IPOs to come are US Foods Holding Corp, which is planning to raise $1 billion in order to repay some of its debt, and the recent Apple (NASDAQ: AAPL) investment car-hailing service Didi Chuxing which announced its plan of a US IPO in 2017. Upcoming IPOs can be followed on Nasdaq’s IPO page.
IPO Investment Strategies
The first investment strategy is to invest in an IPO ETF that follows new market entrants and removes companies from the index after two years from the IPO. The below chart shows the increased volatility in relation to the S&P 500 an IPO ETF has.
Figure 8: IPO US ETF and S&P 500 returns since 2010. Source: Renaissance Capital.
This might be a good investment in times of economic prosperity and optimistic outlooks as the IPO index has outperformed the S&P 500 from 2010 up to mid-2015, but at the first signs of market trouble investors flee risky assets and the previous gains are quickly lowered. When counting on a market rebound, an IPO ETF might be better than regular investments as it is more volatile. Except for trying to time the market and making extra returns by taking advantage of the IPO companies, additional volatility another method is to pick individual stocks.
According to NYU professor Aswath Damodaran, an IPO stock picker has to have the following skills:
- Have the valuation skills to value companies with limited information and considerable uncertainty about the future, so as to be able to identify the companies that are under- or over-priced.
- Gauge the market mood and demand for each offering in order to flip the investments as soon as profits are made.
- Play the allotment game well, asking for more shares than you want in companies which you view as severely under-priced and fewer or no shares in firms that are overpriced or that are priced closer to fair value.
In simple words, IPO stocks reflect the situation on the markets but with a multiplier attached to them. Investors quickly flee new stocks on any signs of trouble as new companies have more difficulties in attracting capital and are more difficult to value due to their lack of historical performance. As there are currently several risks incumbent onto the general market, it might be better to avoid IPO stocks as further steep declines are possible.