A Few Things to Consider Before Investing in IPOs

If you purchased $1,000 in shares of Microsoft near its initial public offering (IPO) price in 1986, your investment (if you held on through thick and thin) would be worth roughly $1.6 million today. Who wouldn’t want to travel back in time and buy a few shares?

But would you time travel for Webvan, Tintri or eToys? Not familiar? That’s because they all went bankrupt. But at one point each promised to be the next “big thing” and you could’ve owned a slice of the action after their high-profile public offerings. Buzzworthy companies enter the markets all the time: From 1999 to 2018, there were over 3,500 IPOs. But in that same timeframe, the total number of publicly listed companies in the U.S. fell from 7,200 to 4,300. For every Microsoft, there are a host of other companies that never live up to expectations.

Still, millionaire-making potential makes investing in IPOs alluring, but the road to riches can be bumpy — especially early in the company’s life as a public entity. If you’ve got your eyes on a company that just went public, it’s important to understand some of the factors that can make them volatile. Before clicking “buy”, here are a few things to consider in order to approach investing in IPOs strategically while maintaining a long-term focus.

JOCKEYING FOR THE RIGHT PRICE

Financial firms that do all the legwork to bring a company public earn commissions based on the gross proceeds from the offering. Their job is to make those shares attractive to big financial institutions, corporations and investors that buy shares before they hit the stock exchange. At this point it’s important to note that average investors typically won’t get a chance to buy shares at the IPO price. Instead, their opportunity to buy arrives when big banks and big investors sell their shares on public exchanges.

Underwriters are trying to price shares attractively while also generating their commissions and maximizing returns for the issuing company. As a result, the share price doesn’t always reflect the fundamentals or the collective wisdom of the market. If investors disagree with the price, you’ll probably see a lot of volatility when they hit the exchange.

IPOs also monetize the illiquid ownership stakes held by founders and early investors – basically allowing them cash in, which means there are a lot of incentives to sell. Usually, insiders are barred from selling their shares for 90 to 180 days after trading begins, known as the lock-up period. Again, that can make things volatile if insiders and other big investors choose to sell when that lock-up expires.

THE VIEW IS STILL PRETTY CLOUDY

Companies such as Coca Cola or IBM have been publicly traded for decades, which means there’s a mountain of data about their cash flows, balance sheet, and overall capital allocation strategies. That gives analysts pretty good insights into their operational strengths and weaknesses, allowing them to better forecast earnings. However, investors in newly public companies don’t have that trove of data to study, which means sentiment — and the share price — can shift rapidly when companies begin reporting results. That’s because investors and analysts alike are still getting a feel for how management operates.

Before a company begins trading, the best source of information for investors comes via the S-1 form, which companies file with the U.S. Securities and Exchange Commission before going public. The S-1 contains a basic overview of the business, what it plans to use its proceeds for, risks to its business model, as well as a snapshot of the company’s financials. If you’re planning on investing in an IPO, the company’s S-1 should be on your reading list.

EMOTIONS CAN RUN WILD

People like being first to get their hands on a new gadget; the first to see a new movie; the first to climb Mt. Everest or El Capitan. That first-mover impulse is the same when a high-profile company goes public. That human desire to be among the first people to invest in the next Microsoft or Amazon means the stock price can grow far removed from the company’s fundamentals while emotions and the fear of missing out (FOMO) pushes prices higher and higher as investors rush in. Sometimes the attention is warranted, but other times it’s a bubble waiting to burst.

Consider this: In October 1999, when FOMO hit a peak, the collective market value of 199 high-flying internet companies tracked by Morgan Stanley was $450 billion. Their combined profits? Negative $6.2 billion. It’s no wonder things didn’t go so well for early investors shortly thereafter. On the other hand, Facebook’s IPO was considered a flop, falling from $38 a share to a low of $17.55 the year it went public. On July 25, 2018 Facebook shares hit an all-time high of $218 – more than five times its IPO price.

Therefore, the key thing with a recent IPO is to always focus on the reasons you invested in the first place. Having a clear, strategic reason for buying those shares will be key to shaking off the herd’s dramatic mood swings and sticking to your thesis.

WHY DID THE COMPANY GO PUBLIC?

There are several reasons a company goes public, but they’re all about the money. Companies use proceeds from an IPO to pay down debt, fund acquisitions or to fuel rapid expansion — and they all carry some execution risk. A 2017 study found companies that use post-IPO proceeds to eliminate debt tend to be the highest underperformers in the following three years as a public company. That’s compared to companies that used IPO funds for purposes other than debt repayment.

Some companies that go public are relative infants, pioneering new and unproven technologies that may never gain traction. Other companies that IPO have been proving their business models for a long time. Levi Strauss, for example, is a 166-year-old company that went public in 1971, was taken private for the last 34 years, before coming back to public markets in March 2019. All told, it’s important to understand how your investment dollars will be used by the company you invest in.

DOES IT FIT WITH YOUR PLAN?

Again, there’s nothing wrong with investing in a newly public company that you’re excited about, but like all investments it's risky. And, as you can see, fresh IPOs have a few additional risks that can distort the price one way or another. However, knowing some of these factors that might drive stock volatility early on can help you tune out some of the noise and focus on the big picture. Why are you investing in the first place? How do investments factor into your plans and aspirations for the future?

Ultimately, the goal of investing is to balance risk and reward to strategically build long-term wealth. Historically, one of the best ways to balance risk is to maintain a diversified investment portfolio that consists of large to small U.S. stocks, international stocks, fixed income, commodities, real estate and other assets. While investing in an IPO has potential, you don’t necessarily want to sacrifice portfolio diversification in the process. Therefore, it’s important to develop and stick to a strategy. When you do, you’re no longer leaving your life to chance but instead giving yourself opportunities to choose how you want to live. If you’re interested in building a cohesive strategy, a financial advisor can help you fit investments into a plan that works for you.

All investments carry some level of risk including the potential loss of principal invested. No investment strategy can guarantee a profit or protect against loss.