We’ve all heard the story: Someone bought Apple (Nasdaq: AAPL) at $22 per share when it had its initial public offering in 1980 or Facebook ( FB) at $42 per share on its first trading day and retired filthy rich at age 37.
In some ways, this has become the new American dream: Make it big on the stock market so you can retire young. It seems reasonable; after all, anyone can invest in an IPO.
Investing in IPOs “sounds sexy,” says Bill Higgins, a financial advisor at Vestory in Bellevue, Washington. Investors think, “‘Man, am I going to get in on the next Apple or Facebook?’ But you have to look at the facts.” And the facts suggest that IPOs are not all they’re hyped up to be.
[See: 10 Skills the Best Investors Have.]
“The investment reality is sometimes quite different than the buzz or the excitement around their IPO. That’s why we always recommend being cautious about buying newly public companies,” says Kate Warne, an investment strategist with Edward Jones in St. Louis. It’s not that all IPOs are bad investments, she says. It’s that “many of them aren’t good, and we don’t think there’s any good way to tell which are which.”
Most IPO companies aren’t profitable. Typically, you want to invest in companies that are making money, which “eliminates a lot of IPOs because many of them are losing money at the point when they go public,” Warne says.
A company chooses to go public because it needs another source of capital. A private company that’s already making strong profits has little incentive to go public. According to a 2017 report on IPOs by Jay R. Ritter, Cordell professor of finance at the University of Florida, 38 percent of companies that went public between 1980 and 2016 had negative returns on the day of their IPO.
Even if a company’s early earnings reports look promising, it may not be an indication of positive future returns. Companies often try “to grow quickly in advance of their IPO,” Warne says. As such, they may not always live up to the expectations set by their early earnings reports.
In fact, IPO companies have historically underperformed established public companies of similar size by 3.3 percent on average between 1980 and 2015, according to Ritter’s report. “You’re probably going to do better if you buy more established companies that have a track record” than investing in IPOs, Warne says.
There are a lot of unknowns. Newly public companies come with many questions and few easy answers for investors, Higgins says. For instance, when a company decides to go public, one of its first steps is to hire an investment bank to underwrite the IPO.
These underwriters set the price range for where they think the stock will start trading, but setting a price for something that has never traded before can be a challenge. After the stock begins trading on opening day, its price may vary widely from where it was originally set. The average first-day return for IPOs between 1980 and 2016 was 18.5 percent, according to Ritter. While this may sound promising for IPO investors, the reality is that unless you were allocated shares by the underwriters, you won’t enjoy those gains.
Early prices for newly public companies can also be volatile. Warne says that if you are determined to invest in newly public companies, use limit orders so you won’t end up “paying a price that you’re surprised by.” She adds that “the early price movements really don’t give you much signal about whether the company will eventually be a good investment or not.”
This prompts Higgins to wonder if an IPO’s pricing in its first few days of trading are true, unbiased representations of the stock’s value: “Are all market participants freely assessing it, or is there some unknown information that the investment bank has?”
[See: These IPOs May Be Huge Hits in 2017.]
Analyst reports can’t be trusted. A Chinese wall separates the banking and analyst departments at investment banks that underwrite IPOs. In theory, this should mean there is no conflict of interest between the two groups.
Yet, more often than not, the first report issued by the underwriting investment bank’s analyst team on an IPO is a favorable one, says Saleem Khatri, co-founder and CEO of Instavest, an algorithmic investing service for retail investors in the San Francisco Bay Area. “Banks have to take care of their clients. It would be bad customer service to issue an unfavorable analyst report on a company that was giving your bank a lot of business,” he says.
While analyst reports on newly public companies are “nice to pay attention to,” Khatri says there are better ways for investors to evaluate a newly public company. Investors should look at the company’s fundamentals, such as the size of its market and its competition, rather than analyst projections or early price movements, Warne says. “Is this company entering a growing market? Do they have a competitive advantage? And are they going to be able over time to grow their profits quickly, because that’s what you’re expecting when you think about buying companies that are just going public,” she says.
If you must invest, try an IPO fund. From an investor’s standpoint, there are two big problems with investing in an IPO directly. “When you buy an IPO you’re placing your hard-earned investment money on an individual stock, so you’re not getting diversification, and then you’re compounding it with a stock that doesn’t necessarily have a track record in the publicly traded arena,” Higgins says.
Many of the companies “won’t make it for reasons that you couldn’t have foretold at the point when they went public,” Warne says. In fact, newly public companies may be at greater risk of going bankrupt as they have yet to prove themselves on the public stage. The value of a mutual fund that invests in IPOs, on the other hand, is unlikely to go to zero. And even if the fund’s management company went bankrupt, creditors can’t claim the assets in a mutual fund because they are held in a separate trust for investors.
Compared with a fund that invests in many IPOs, “buying an individual stock is less about investing and more about speculation,” Higgins says. So if you must buy an IPO, Khatri says to consider an exchange-traded index fund such as First Trust US Equity Opportunities Fund ( FPX), the Renaissance IPO ETF ( IPO) or the Renaissance International IPO ETF ( IPOS), which give you a cross section of newly public companies to invest in. He says the downside to these ETFs are the higher fees. In addition to commissions, the First Trust and Renaissance IPO ETFs both have expense ratios of 0.6 percent, with the Renaissance International IPO ETF carrying an expense ratio of 0.8 percent.
[See: 10 ETFs to Buy for Aggressive Growth.]
Even then, only invest money you can afford to lose. For most investors, Higgins says, this means limiting IPO investments to 5 percent of their portfolio.
More from U.S. News
9 Psychological Biases That Hurt Investors
The New Sector Funds: 10 Thematic ETFs
8 Boring Stocks With Soaring Potential
IPOs Often Are More Hype Than Substance originally appeared on usnews.com
