Don’t Get IPO FOMO

by: Richard A. Anderson

On Friday, Uber went public in the what is the biggest initial public offering (IPO) so far this year. Earlier this month, Beyond Meat went public with less hype and saw its price skyrocket 163% in its first trading day, making it the best-performing first-day IPO in nearly two-decades. Beyond Meat is a producer of plant-based meat substitutes founded in 2009. The company’s Beyond Burger is sold at Whole Foods and restaurants chains around the country.

As of Friday, there have been 53 IPOs this year. Of these 53, 35 had positive returns on the first day with the average first-day return being just above 21%. The lure of big gains may have you suffering from FOMO, or fear of missing out. However, history suggests positive first-day returns are not always a sign of things to come. Before jumping into the details, let’s first cover some IPO basics.

What is an IPO?

An initial public offering, or IPO for short, is when a privately-owned company becomes a publicly-traded company by selling shares to the public and starts trading on a stock exchange. Private companies “go public” for a number of reasons including maximizing shareholder value, providing liquidity to investors and employees, raising capital for future expansion, increasing company awareness, and using stock as a currency for mergers and acquisitions. An IPO is the culmination of a lengthy process that involves hiring investment bankers and broker dealers to prepare the offering and set the initial offering price.

How can you participate in an IPO?

The investment banks and broker dealers that lead the IPO process, which is referred to as underwriting the IPO, allocate shares to institutional and individual investors. Receiving shares at the offering price before the security is first publicly traded is called “participating in the IPO.” The vast majority of IPO shares are allocated to institutional investors, such as pension funds, hedge funds, insurance companies, and mutual funds. It is very difficult for the typical investor to participate in an IPO.

What are the historical returns from investing in IPOs?

Returns from investing in IPOs are often measured using two methods. The first is to measure the first-day return, which is the difference between the first-day closing price and the IPO offer price. Only investors who participate in the IPO are able to capture the first-day return. The second measure is medium- to long-term returns. This measurement starts from the closing price on the first-day until anywhere from six-months to five-years later.

In the last 40-years, the average first-day return is 18%. Though, there is a wide range of first-day returns. Some IPOs return much greater than 18%. Many first-day returns are around 0% because investment banks stabilize the share price to prevent it from dropping below the offer price.

On the other hand, medium- to long-term returns excluding the first-day returns are not as fruitful, especially as the holding period extends beyond six-months. After six-months, lock-up agreements that prevent pre-IPO shareholders from selling their shares typically expire. When the lock-up expires, there is historically downward pressure on the stock price as early investors sell their shares for liquidity and risk-reduction.

University of Florida professor Jay Ritter has conducted a great amount of research on IPOs. His research has found that over 60% of IPOs from 1975 – 2011 had negative five-year buy-and-hold returns after their first-day close. In contrast, a small number of IPOs produced returns in excess of 1,000%.

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The Bottom Line

IPOs can offer attractive returns if you can participate in the IPO. However, if you’re buying shares in the secondary market the return opportunity is less attractive.

The flurry of recent IPOs with significant positive first-day returns may have you wrestling with FOMO. IPOs are the ultimate lottery-ticket investment, offering potential for huge gains with a low probability of winning. For every successful IPO that we wish we would have bought, there are 10 unsuccessful IPOs that we are happy we didn’t buy. But we don’t remember those because we’ve moved on to the next hottest IPO. So, while you may be kicking yourself for missing the Beyond Meat or Pinterest IPOs, you can congratulate yourself for also missing the not so successful IPOs of Lyft and Snapchat.