Are you ready for the next hot IPO?
An initial public offering, or IPO, issued by a popular company can seem like a very tempting opportunity to buy into an early-stage stock. After all, popular companies with popular products are often believed to be destined for great profitability. In reality, by the time most individual investors have the chance to buy into an early stage company, they’re late to the party. The greatest profits have already been realized by other people. One of the common misconception of IPOs is that you’re getting in on the ground floor. In fact, IPOs are quite the opposite. When a company issues an IPO, the shares are first purchased by an underwriter. The underwriter then sells those shares to the public - but typically to their favorite clients first.
While buying an IPO may seem like a great short term opportunity, it typically favors the company’s earliest investors -- including company founders, initial employees, venture capital firms and private equity funds. Those investors who bought into the company while it was still private, are looking forward to the IPO as means to “cash out,” and sell their shares at the highest possible price. Historically this has been an ideal time for them to do so. Recent data from the University of Florida shows that initial public offerings from 1980-2014 had an average return of 17.9% on their very first day. Impressive. Most IPOs actually then go on to underperform other firms of the same size by an average of 5.13 percent per year. Over the next 3 years, that's a whopping gap in return of 17.8%.
It’s tempting for investors to get excited about the latest and greatest product or technology and want to get in on the potential upside by investing in initial offerings of these companies. In reality, IPOs are risky and historically they underperform their market peers for some time. So, regardless of the company, investors should avoid the hype surrounding an IPO, and instead, focus on the keys to successful investing. Stick to a broadly diversified investment strategy, rebalance over time, and stay disciplined to your long term plan.
Source: “Initial Public Offerings: Updated Statistics on Long-run Performance,” J. Ritter, 03/08/2016, University of Florida, http://site.warrington.ufl.edu/ritter.