Is it a Good Idea to Buy a Recent IPO?
In case you missed it, shares of the company Robinhood (ticker: HOOD) went public last week. “Going public” simply means the company stock now can be easily bought and sold by public investors. It also means that those private investors in the company now have a much larger number of potential buyers, especially those looking for the next “hot stock.” The question of buying an IPO (initial public offering) has less to do with the actual company in question and more to do with the probabilities of success in general. Let’s examine some of the basics and see what to expect if you want to buy the next big thing.
Private vs Public
If a company is private, it means that there is not a liquid market where an owner/shareholder can sell their stake in the company. It can still be done, but it isn’t as easy as when a company is listed publicly. If you are an employee at one of these private companies who has been granted stock, there should be an opportunity to sell your stock back to the company or to a private investor, but that is outside the scope of this blog.
Buying an IPO
When a widely known company like Uber or Facebook goes public, there is a buzz surrounding it and investors want to get their piece of the pie. Unfortunately, it is not that easy. This is because there are restrictions on who can buy directly from the company. Banks that are in charge of the distribution of shares will allocate a large portion of the shares for sale to institutional investors like mutual funds. You may have access via a brokerage platform, but those shares are typically reserved for the clients who generate the most revenue for that brokerage. It is worth noting that Robinhood bucked this trend, as is their wont, by allocating a large percentage of the IPO to account holders.
So, what can you do? Buy on the first day of live trading via your online brokerage platform. This is not recommended because prices can swing wildly on the first day and unless you are comfortable with submitting different types of orders, you could be stuck with a very unfavorable price paid. If you are going to buy an IPO, wait for the dust to settle and get a price you are comfortable with rather than succumbing to the fear of missing out in the first day frenzy.
Odds of Success
Jay Ritter is a professor of finance at the University of Florida and he is most well-known for his work on the history of IPO performance. His data makes one thing abundantly clear: buying on a stock’s first trading day puts investors at a severe disadvantage in the long run. For example, for 7,963 IPOs tracked from 1975-2015, a whopping 59.5% of those had a negative return after five years (assuming the closing price on the first day was the purchase price). Even if the data is filtered to only include companies with at least $100M of revenue prior to IPO, that figure is still 46.8%. (Data available here). Long story, short: the odds are not in your favor.
Investors seem to have an insatiable desire to invest in the next big thing. Buying the next Amazon, Microsoft, or Apple from day one is something that would be hard not to bring up at dinner parties. Oh, and you would be fantastically rich, too. There are two issues here. First, it’s basically impossible to ascertain what those winners would be from the outset. For example, Amazon sold books online to start – now, they have invaded pretty much every aspect of our life. Who would have predicted that? Second, those who bought at the beginning have had to endure multiple face-numbing drops in the value of the stock. Back to Amazon, it was down almost 95% from its high back in 2001. The only people who held were most likely those who forgot they owned it. Hindsight is 20/20, as they say.
Lest I throw too much cold water on the notion of buying stocks from their IPO, buying stock in a company you like and whose products you use can be a great way to participate in the potential of the next big thing. Just make sure that you are realistic about the odds and that you are cognizant of the risks involved.
Author: David Rath, CFA
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