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IPO’s: A Great Investment Opportunity or a Sucker’s Bet?

By: Investor Solutions

By: Investor Solutions, Inc.

There’s nothing like the seductive allure of buying an IPO at its offering price, riding the stock up, and then flipping it for a pile of cash. Find the next Microsoft at its inception and you are set for life, right? Pinch yourself….Fantasy Island went off the air decades ago! Public offerings are about companies needing to raise capital for operations or new projects. They are not a one way ticket to riches for the average investor. In fact, they make pretty lousy investments for most people, so beware.

IPO Basics

An Initial Public Offering, or IPO, is the first sale of stock by a private company to the public. IPO’s are often smaller, younger companies seeking capital to expand their business. But, they can also be established, private companies looking for additional cash infusions.

Companies wanting to go public usually hire investment banks to “underwrite” the process. Underwriting is the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities, for both equity and debt.

The underwriter may put together a consortium of several investment banks and brokers to distribute the stock for the issuer. The underwriter agrees to pay the stock issuer a certain price for a minimum number of shares, and then must resell those shares to buyers, typically institutional clients of the underwriting firm or to its related brokerage firms. Additionally, each member of the consortium agrees to resell a certain number of shares to its most exclusive clients. For its underwriting and distribution services, the underwriters charge a very handsome fee plus the subsequent commissions for trading the stock.

A “hot IPO” defines an IPO that often rises dramatically above the offering price on the first day. Qualified investors buy them in the hopes of “flipping” them for an even higher profit. An IPO stock at the “release price” is usually not available to most of the public-and that means the average Joe. If the average Joe is getting IPO stock offerings, it’s usually a stock you don’t want anyway.

The Numbers

Investing in a brand new stock is always risky. Sure, as an investor you just might get lucky and hit a few homeruns with an IPO investment. However, you are far more likely to strike out “at bat” (think Vonage).

Ongoing research by finance professors and IPO experts like Tim Loughran and Jay Ritter demonstrates that the average return on IPO’s issued between 1970 and 1990 is a mere 5% annually (median returns might actually be lower). Compare that to the S&P 500 which produced an annualized return of 10.81% for the same period. According to Jay Ritter, finance professor at the University of Florida,” the typical IPO lags for up to five years after it comes to market”. Similarly, Ritter and Professor Ivo Welch have concluded that IPO shares perform 23.4% worse than shares of comparable seasoned companies in the first three years and actually have negative returns in that time period.

According to Richard J. Peterson, chief market strategist for Thomson First Call, over 5,000 companies went public between 1989 and 2000. By 2004, nearly one-third of those companies were down over 50 percent since their stock market debut or out of business. Only one-fifth were worth at least twice their opening day price.

With the odds like that, I can’t imagine why anyone would buy an IPO unless you had money to burn or hung around with the Trumps or Rockefellers.

But I’ve heard….

People have obviously made money in IPO’s before. You cannot dispute that fact. We all know that the va-va-voom market of the nineties made gazillionaires out of several fortunate people.

How? For starters, they probably got the IPO shares early, as close to the original IPO price as possible. They were either lucky, had close ties to the underwriter or received a “friends and family” allocation (trust me, “average Joe” investor was not included in that group). They then had to sell early, timing it just right before the eventual decline of the stock naturally followed. For every winner, there were a series of losers–someone who bought the stock as it started to decline then sold to the rest of the suckers that followed.

So, yes, opportunities do exist, however it’s not the easy money so often associated with the IPO market. Instead, IPO’s are lucrative for the banks that rake in the commissions and spreads associated with the IPO.

Remember those handsome fees mentioned several paragraphs ago? The IPO “sread” is the difference between the underwriting price received by the issuing company and the actual price offered to the public. Those spreads can reach as high as 7%. Therefore an underwriting consortium selling $250 million worth of shares in an IPO would receive fees close to $17.5 million! A nice pay day for the banks if you ask me.

In summary, if you think that buying an IPO is your one way ticket to Trumpville, think again. Approach the IPO market with a giant degree of skepticism. The little guy can get easily crushed on this playground. A broadly diversified portfolio of equity index funds can run circles around and IPO driven investment strategy, especially in terms of risk control.