One Cure for IPO Envy: Historical Data

06/01/2011 12:00 pm EST


John Heinzl

Reporter and Columnist,

For every Google, there are many more initial public offerings that underperform, writes John Heinzl, reporter and columnist for Globe Investor.

Are you suffering from IPO envy? Symptoms include sweaty palms, a racing heart, and a gnawing feeling that everyone but you is cashing in on the latest get-rich-quick stock.

With initial public offerings such as LinkedIn (LNKD), Zipcar (ZIP), and Yandex (YNDX) flying out of the gate on their first day of trading, it’s easy to feel like you’re being left behind. It doesn’t help when the news media trumpet every IPO with banner headlines and speculation about which company—Facebook? Twitter? Groupon?—will be next.

Well, get a grip. The truth is, you don’t need IPOs to build wealth. In fact, there is plenty of evidence that IPOs will make you poorer, not richer.

“A wealth of research demonstrates that IPOs have, in general, lousy returns with very high risk,” William Bernstein writes in The Investor’s Manifesto: Preparing for Prosperity, Armageddon, and Everything in Between.

Sure, some IPOs hit it out of the park. Google (GOOG), for instance, is up more than 500% from its IPO price of $85 in 2004. Yoga wear retailer Lululemon Athletica (LLL) has soared about 400% since its debut in 2007.

But countless other IPOs have flamed out. Take Smart Technologies (Toronto: SMA), a Calgary-based maker of electronic whiteboards that went public at $17 a share last July in the biggest Canadian tech offering in a decade. Hammered by falling profits and a weak sales outlook, the stock has plunged about 60%.

And pity anyone who bought Zipcar or LinkedIn after their initial pop.

  • Zipcar—a car-sharing company that has never made a profit—is down about 10% from its closing price on the first day of trading.
  • LinkedIn—which trades at an eye-popping 500 times trailing earnings—is down more than 12%.

Such post-IPO letdowns are typical, says Jeremy Siegel, author of The Future for Investors: Why the Tried and the True Triumph over the Bold and the New.

The Wharton finance professor examined the performance of about 9,000 IPOs from 1968 through 2003 and found that nearly four in five underperformed a small-cap index. Of those, close to half trailed the index by more than ten percentage points annually, and more than one-third lagged by at least 20 percentage points.

Returns were calculated from the original IPO price, so the results included the first-day jump that many IPOs experience. What’s more, portfolios of IPO stocks were more volatile than the small-cap index.

“The absolute worst time to buy a newly issued firm occurs during hot IPO markets, when investors clamor to buy any new firms in the ‘must-have’ industries,” he says.

Renowned value investor Benjamin Graham also advised investors to be wary of new issues, for a couple of reasons: “The first is that new issues have special salesmanship behind them...The second is that most new issues are sold under ‘favorable market conditions’—which means favorable for the seller, and consequently less favorable for the buyer.”

Not everyone agrees that IPOs are a loser’s game.

Renaissance Capital, an IPO research and investment firm in Greenwich, Conn., says in a report that IPOs get a bad rap because the historical data are misleading.

Siegel’s study, for instance, assumed an equal dollar amount was invested in each IPO. But this is an unfair comparison, it says, because most equity indexes are weighted by market capitalization, which gives more influence to larger, established companies that tend to perform better.

If one also weights IPOs according to their market cap—giving less influence to smaller, less proven companies—IPOs actually outperform the broader market, Renaissance says. Still, the firm—which manages the Global IPO Fund—agrees that investors need to navigate the IPO market with caution.

“The IPO class of equities will have its excesses and it will have its attractive periods,” it says. Superior risk-adjusted returns are possible “especially...during periods when the excesses have been squeezed out of the market and only the fundamentally strong and most attractively valued companies are able to go public.”

That doesn’t sound like now—which is all the more reason to treat your IPO envy symptoms with a cold shower, not a call to your broker.

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