Buying IPOs is a Losers Game
Who wouldn’t have loved to buy Google’s IPO in the $80s? (It currently trades for $280.) There are countless examples of IPOs that in hindsight would have made us rich. If only I could have foreseen the huge returns offered in Dell, Microsoft, or Cisco and avoided the countless IPOs that have floundered, I could have made a killing.
But I can’t foresee which companies will be successful. And I imagine you have the same problem. (Of course, in hindsight, it seems obvious and next time –of course, next time — we will pick the right ones.)
In the meantime, I am going to play the odds — and the odds are that IPOs will not perform well over the long-term.
First, IPOs have not performed well in the past. The relative performance of IPOs verses a small stock index (it’s closest comparison group) is abysmal. According to study in The Future For Investors by Jeremy J. Siegel, in 29 out of the 33 years a portfolio built of IPOs underperformed a small stock index portfolio. And in the four years when the IPOs outperformed, it did so by a small margin. In addition, the IPO portfolios had significantly higher standard deviation of return (the most popular measure of risk). The statistics cross a wide range of IPO markets so it is not one period that is driving the results.
On a side note, the IPO markets of the late 90s showed the worst returns. This coincides with when most of us were hearing about IPOs daily and were most likely to “invest” in them.
Second, IPOs occur because of two main reasons — investors want out or the company needs more capital than it can raise in the private markets. Both of these are usually signs of trouble. The original investors know more than we do about the company — and they want out! They want out because they believe that — even after paying the substantial underwriting costs — they can get more than fair value from the buyers of the IPO.
If these companies cannot raise the capital they need from private purchasers, it means that the smart money is not biting and it may be an indication that the company is going to need to continue to raise capital in the future. Of course, companies that burn through capital do not create value for shareholders. For example, Seigel showed that capital expenditures/sales are negatively correlated with shareholder returns. ibid.
So, despite all the headlines about Google’s, Microsoft’s, Dell’s, and Cisco’s phenomenal results, you haven’t missed the party if you have stayed on the sidelines for all of these IPOs. You would, in all likelihood, be ahead of your neighbors who participated because as Benjamin Graham stated in his seminal work, The Intelligent Investor, “Most new issues are sold under ‘favorable market conditions’ — which means favorable for the seller and less favorable for the buyer.”
Financial Reference » IPO Fund said,
September 11, 2005 @ 7:45 pm
[…] In addition, despite their claims that their strategy will produce market beating returns, I have significant doubts because (1) IPOs have traditionally underperformed (see Buying IPOs Is a Loser’s Game) and (2) according to a recent Morningstar study, high expenses mean low returns. […]
Josef Schuster said,
November 5, 2005 @ 9:14 am
11/4/2005: IPOX Indexes make new multi-year highs
Since launch of the IPOX-30 Van Kampen sponsored product on July 20th, the IPOX-30 has outperformed the S&P 500 by 650 basis points or the Russell 2000 by 900 basis points. Over a 15-year horizon, the IPOX-30 has beaten the Nasdaq-100, only at 60 percent of its standard deviation.
The “IPO underperformance story” is outdated, all of the academic IPO research uses an equally-weighted sample set-up in event time. Any top US business school academic will verify this.
The IPOX Indexes are the first product addressing one of the most pervasive empirical anomalies in Finance: the dispersion in long-run IPO returns. i.e. while many companies go public (annually around $140bn of market cap is being created through IPO and spin-off activity annually), exposure to only few can add substiantial diversification benefits and alpha to a portfolio.
The IPOX-30 Index is an index of the top 30 companies in the IPOX Composite Index ranked quarterly by market capitalization. The IPOX Composite captures a (screened) universe of US IPOs and spin-offs. After entering the IPOX-Composite Index on the 7th trading day, companies remain in the IPOX Composite until their 1000th trading day anniversary on the stock markets. Current companies include GOOG, CME, DEX, WYNN, PA, CE, PRU, PFG, WC, WLP etc.
This allows for a buy-and-hold exposure to the largest and best performing IPOs during the past four years, a totally systematic and disciplined approach to add alpha to a portfolio.
Update your thoughts on IPOs: think IPOX
For more info, see www.ipoxschuster.com and discuss with josef@ipoxschuster.com