Owning the Next Big Thing: Should I Buy into an IPO?Submitted by Bernhardt Wealth Management on November 11th, 2019
A friend of mine tells the story of his brother-in-law, who worked at Wal-Mart Store #7, which opened when the current retail giant was still a small regional discount store that few had ever heard of. “If only I’d bought the stock when I started there,” the brother-in-law would lament, “I’d be mega-rich today.”
It is axiomatic that hindsight is 20-20, and we’ve all heard similar stories: those who bought Yahoo.com stock in the early days of the internet; those who got in on the ground floor at Facebook. More recently, we’ve seen the headlines about how many “instant millionaires” were created when companies like Uber and Pinterest start trading publicly for the first time.
The financial media typically creates lots of excitement when startup companies do an initial public offering of stock (IPO). Particularly with a popular company, it isn’t at all unusual to see those new shares jump in price by as much as 17% when they first become available to the public. Naturally, then, many investors wonder if they shouldn’t be investing in IPOs; after all, if there’s money to be made, as often seems the case, why not get in on the action?
But as with most such matters, the devil is in the details. There are a couple of things to keep in mind about IPOs, especially as they apply to individual investors, that make those high first-day profits much less than a sure thing.
First of all, it isn’t easy for an individual investor to purchase shares during an IPO. Instead, the allocation of shares is usually controlled by the investment banks underwriting the offering. These large financial institutions, including familiar names like Bank of America, JPMorgan Chase, Citigroup, and others, will typically allocate the majority of shares in an IPO to large institutional clients like pension funds, insurance companies, and other entities that can purchase huge blocks of shares. Once these orders are filled, brokerage firms may get some blocks of shares, which they will then allocate to their clients in order of ability to purchase—much like the allocation process used by the original underwriters. In other words, by the time the supply of shares reaches the individual investor, the number of available shares may be pretty small. It isn’t unusual, for example, for an individual investor in an IPO to receive 15% or less of the number of shares they hoped to purchase.
Another important factor involving the allocation process is that the more desirable the IPO is perceived to be, the more likely it is to be fully subscribed—or even over-subscribed—by the large institutional clients. In other words, if shares in an IPO are readily available to individual investors, it is often because the issuing company is not seen in a favorable light.
According to empirical research by Dimensional Fund Investors, IPOs have mostly underperformed the broad market indexes during the last 27 years. Examining some 6,000 IPOs from 1991 to 2018, researchers noted that short-term returns typically underperformed market benchmarks, primarily due to the adverse selection described above: IPOs that were available to individual investors tended to be of poorer quality than those allocated to large institutional clients, and the subsequent returns realized by individual investors suffered as a result. But even in the longer term, the study found, total returns on IPOs lagged market indexes. Even shares purchased on the secondary market—after the initial offering period was over—tended to underperform the broad market during the first year.
Part of the reason for this longer-term underperformance may have to do with another important element of IPOs: the lock-up period. Most IPOs require the principals of the company whose shares are being offered—the CEO, CFO, venture capitalists, and other leadership—to hold their shares for a minimum amount of time before they can sell them on the open market. The main reason for this is that mass selling of shares would tend to depress the stock price, which the underwriters of the IPO, as well as other stakeholders, want to avoid. Lock-up periods vary with each IPO but can be anywhere from three to six months in length. Thus, when the lock-up period of an IPO expires, it’s not unusual to see large amounts of selling activity, as the principals seek to diversify their holdings by selling shares and making other investments.
None of this is to say that it’s impossible to make money in an IPO. Especially if you work for the company making the offering, an IPO can be a very exciting time that provides an opportunity for great financial gain. But it’s vital to go in with your eyes open, understanding the limitations imposed by the terms of the IPO and the realities of the markets.
As always, we wish you Buen Camino on your personal, professional and financial journey. Contact us if you have any questions.