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Investing in Initial Public Offerings (IPOs) - YouTube
Channel: Ben Felix
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- An initial public offering,
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when a successful private company
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decides to offer shares to the public,
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is an exciting time for the company,
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its original shareholders,
and the investing public.
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All of the excitement and
publicity around an IPO
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often lead investors to want
to get in on the action.
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If you can get in on the
ground floor of an IPO,
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that is, get an allocation
in the initial share offering
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before the stock starts trading,
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there is evidence that you
are likely to make a profit.
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IPOs tend to be underpriced.
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While this might seem like an
obvious way to easy profits,
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there are a few crucially important things
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for you to consider.
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I'm Ben Felix, Portfolio
Manager at PWL Capital.
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In this episode of Common Sense Investing,
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I'm going to tell you why IPOs
don't live up to the hype.
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(driving electronic music)
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It is well-documented that
IPOs tend to be underpriced.
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In other words, when the
underwriter determines the price
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that the company should offer
its shares to the public,
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the data show that they
tend to set a price
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below where the market
will price the shares.
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This creates the perception
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of a real opportunity for investors
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to make a quick profit on
the first day of an IPO.
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The media often enjoy reporting
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on the large first-day profits
that IPO investors make.
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The challenge for most investors, though,
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is that getting in on the initial
allocation is really hard.
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The majority of the initial allocation
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generally goes to institutional investors,
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which we will touch on again in a minute,
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while the allotment for retail investors
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is likely to be allocated
to larger brokerage clients.
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Fidelity describes the allocation process
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for retail investors as follows.
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Each customer who wants to
participate in an IPO offering
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is evaluated and ranked
based on his or her assets
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and the revenue they generate
for the brokerage firm.
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Typically, customers with significant
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long-term relationships
with their brokerage firm
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will receive higher priority
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than those with smaller
or new relationships.
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This statement from Fidelity is supported
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by a 2018 paper in the
Journal of Finance titled
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"Quid Pro Quo?
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What Factors Influence IPO
Allocations to Investors?",
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where the authors examined 220 IPOs
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from January 2010 through May 2015
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to test the determinants
of IPO allocations.
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They found strong support
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for the brokerage revenues
associated with a client
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being a significant determinant
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of investors' IPO allocations and profits.
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Based on this, if you are able
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to get in on an initial allocation,
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unless you're a high
value brokerage client
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or an institution,
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you're likely getting in on an IPO
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with a poor expected outcome.
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There is adverse selection
in IPO allotments,
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where those with expected
weak first-day returns
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have been easier to get
access to ahead of time.
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I think it's safe to say that, in general,
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smaller retail investors
and DIY investors,
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who are not generating
significant revenues
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for their brokerage firm,
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will be hard pressed to get
in on the initial allocation
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when a hot company goes public.
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Interestingly, there is
evidence that new mutual funds
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use their institutional
status and relationships
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to get in on initial IPO allocations
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in an effort to boost their returns.
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This was detailed in a 2017 paper,
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"IPO Allocations and New Mutual Funds"
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by Frankie Chau, Yi Gu,
and Christodoulos Louca.
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They looked at data from 1998 to 2015,
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and found that new mutual
funds tend to outperform
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during the first six
months after inception.
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This outperformance was concentrated
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in new funds that held
underpriced IPO stocks.
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After the first six months,
performance fell substantially.
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The suggestion in the paper
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is that a fund company
might choose to allocate
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all of their IPO allotment to a new fund
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in an effort to boost its performance
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to attract new investors.
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While this works to get an initial boost,
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the fund performance
tends to drop off quickly.
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The reason that this information
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is relevant to our discussion
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is that it shows the level of competition
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for initial IPO allotments.
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I wouldn't take this as a signal
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that all new mutual
funds will perform well.
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Keep in mind, it is easy
to identify the funds
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receiving preferential IPO
allocations after the fact,
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but I wouldn't start
speculating on new mutual funds
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in an effort to profit
from this phenomenon.
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All right, so you're
probably not going to get in
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on the initial allocation
when a company goes public,
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but that doesn't mean
that you can't buy shares
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on the first day of trading.
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Once the shares are listed
on a stock exchange,
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many of the people holding the shares
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will want to realize the profit
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from the likely underpriced IPO,
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and you could be the one to buy them.
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The performance of IPOs after
the first day of trading
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has also been studied extensively.
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In the March 2017 paper,
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"The Long-Term Performance
of IPOs, Revisited,"
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Daniel Hoechle, Larissa
Karthaus, and Markus Schmid
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detailed the performance of
US IPOs between 1975 and 2014.
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They looked at a total of 7,487 IPOs
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over time periods ranging
from one to 40 quarters
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after the first trading day.
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They found that IPO firms tended to behave
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like high beta stocks
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with negative loading to the value factor,
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and that they underperform
for the first two years,
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even when common risk factors
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like size, relative price, and
momentum are accounted for.
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This underperformance gradually declines
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with longer time periods,
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becoming statistically
insignificant after two years.
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In summary of their paper,
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IPO firms have unfavorable
exposure to risk factors,
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with high betas and
negative loading to value,
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but even when those are accounted for,
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IPO firms tend to underperform
for the first two years.
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These findings are also supported
by more recent research.
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In a 2019 paper from
Dimensional Fund Advisors,
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the authors examined 6,362 US IPOs
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between January 1991 and December 2018.
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To evaluate IPO performance as a whole,
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they constructed a hypothetical
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market-cap weighted portfolio of IPOs
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issued over the preceding 12-month period
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and rebalanced monthly.
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They excluded first-day
returns from the analysis.
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They found that, over
the full sample period,
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the IPO portfolio
delivered a return of 6.93%
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with a standard deviation of 27.62%,
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while the Russell 3000 Index,
a US total market index,
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delivered a 9.13% return with
a 14.28% standard deviation.
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They also split the full sample
period into two sub-periods,
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with one ending in the year 2000
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to isolate the high volume of
IPOs over that time period.
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The result for both sub-periods,
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before and after the year 2000,
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exhibited underperformance
relative to the market
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with substantially more risk,
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as measured by the standard
deviation of returns.
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This result corroborates the findings
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of Hoechle, Karthaus, and Schmid,
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who found that IPOs perform
poorly over the first two years.
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The Dimensional paper also applied
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the Fama/French five-factor model
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to the IPO portfolios' returns,
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and found that the
returns are well explained
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by the factors in the model,
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market beta, company size, relative price,
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profitability, and investment.
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This suggests that IPO firms as a group
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have behaved like small cap growth stocks
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with weak profitability
that invest aggressively.
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These types of stocks, whether
they are recent IPOs or not,
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tend to underperform the market.
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What we can conclude from the research
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that we have discussed
in this video is that,
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if you want to make money from IPOs,
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you have to get in on
the initial allocation,
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but doing so, especially for hot IPOs,
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is really unlikely,
unless you are considered
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a highly valued client by your brokerage.
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If you are able to get in
on the initial allocation,
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there's a good chance that it's not an IPO
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that will have a big first-day pop.
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The better the expected pop,
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the more likely the IPO
shares will be allotted
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to institutions and the
largest retail clients.
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If you miss out on the initial allocation,
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and instead buy the shares
on the secondary market
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once they've started trading,
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you're buying into shares
that will likely perform
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like a small growth, low profitability,
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high investment firm,
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which have an unattractive
risk/return profile.
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Even beyond that, let's keep in mind that,
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any time that you buy one stock,
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you probably aren't
going to get the returns
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of the asset class that it belongs to.
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On average, a secondary
market IPO investment
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will give you the poor expected outcome
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of small growth, low profitability,
high investment stocks.
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But unless you are building
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a diversified portfolio
of recent IPO stocks,
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your actual outcome on an
individual stock investment
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will be driven by the
specific risk of the company,
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which delivers a random outcome.
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Thanks for watching.
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My name is Ben Felix of PWL Capital,
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and this is Common Sense Investing.
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If you enjoyed this video,
please share it with someone
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who you think could benefit
from the information.
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And don't forget, if you've run out
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of Common Sense Investing videos to watch,
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you can tune in to weekly episodes
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of the Rational Reminder Podcast
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wherever you get your podcasts.
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(driving electronic music)
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