Investing in Initial Public Offerings (IPOs)
By Peter Mastrantuono
Who doesn't want to invest in the next Amazon or Facebook? Investing in initial public offerings, or IPOs, may be both exciting and profitable, but some caution is advised.
An initial public offering is a process by which a private company sells its shares to the public. By going public, companies are able to raise additional capital to accomplish important business objectives, such as funding business expansion, retiring debt, raising their brand recognition and allowing company insiders and early investors to cash out some or all of their holdings.
While IPOs may offer the potential for outsize growth, the IPO landscape today makes this more difficult than in the past. The reason for this is simple: Companies are going public much later than in earlier years, with early investors, such as venture capital firms, receiving the bulk of the extraordinary gains typically associated with a young, fast-growing business.
For instance, Amazon, Apple and Netflix all went public within five years of their founding. More recently, IPOs for Uber, Lyft and Pinterest all waited between seven and ten years after their founding to go public.
While much is made of the first day of trading for an new IPO—for the 10-year period from 7/1/2009 to 6/30/2019 the average first day return on U.S. IPOs has been 16%, according to Jay Ritter, a Professor at the University of Florida and IPO expert—the longer-term performance is less impressive.
In an analysis performed by Goldman Sachs, an investment bank, the median IPO stock since 2010 has lagged the Russell 3000 Index by 28 percentage points over the first three years from the IPO date (data as of August 28, 2019).
No other than the Oracle of Omaha, Warren Buffet, has expressed skepticism about investing in IPOs, saying in 2016 that investing in IPOs was akin to buying lottery tickets. More recently, though, he may be of a different view, having made a $1+ billion paper gain on his purchase of Snowflake's IPO in September, as the company's shares soared by 111% on the first day of trading.
When investing in an IPO, Goldman Sachs offers five key attributes of the more successful IPOs. They include: The industry sector they occupy (is the firm in a dynamic industry), the age of the firm (the younger the company, the more likely fast growth potential remains), valuation (the higher the valuation relative to the market, the greater the cause for concern), path to profitability (is the company burning cash with little obvious path to earning profits in the near-term) and sales growth (which Goldman Sachs identifies as the most important determinant of long-term outperformance).
For individuals interested in investing in IPOs, they should recognize that access to shares typically go to institutional investors, pensions and a brokerage's best customers—usually high net worth investors.
Nevertheless, individuals can invest in IPOs through a handful of ETFs that invest in companies that have recently had their IPOs. These ETFs do not generally get allotments of IPO shares, but buy shares after public trading begins. They also take very different approaches in terms of the investments they make, so investors should consider discussing these IPO ETFs with their financial advisor.
So far, IPO activity has been high in 2020, with more IPOs expected, including Airbnb, Robinhood, DoorDash, Wish, GoodRx and Bumble, providing investors with a robust and varied menu of new investment possibilities.
Peter Mastrantuono is a contributing writer to MyPerfectFinancialAdvisor, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.