What is an initial public offering (IPO)?
An initial public offering (IPO) is the first public sale of a security.
IPOs occur all the time in the debt markets as governments and large corporations who borrow money usually do so by issuing new bonds. If you are already comfortable with the borrowing entity, a new issue bond can be an effective way to earn a better than average yield. You should only consider participating in a bond IPO if you would otherwise have bought the same bond had it already been in existence at the offered yield. If you have access to a decent bond platform you can readily navigate to listings of new bonds for sale. Click here for pointers on selecting bonds, new or outstanding.
Stock IPOs are the ones that make the news. In fact, when the press and public speak of IPOs, they are usually referring to stocks. Even casual news readers probably know those who bought Apple or Google stock during their IPOs made a fortune while those who bought Vonage lost most of their money and those with Pets.com lost their entire investment.
Why you should avoid stock IPOs
Naturally bad timing
Company officials know better than investors when they can get a good price for their stock. They know when sales have been better than usual; when the company’s gone a long time without any negative events; when favorable publicity might augment perception of worth. Current shareholders of private companies are not forced to sell anything, and yet at the time of an IPO they have decided to sell shares in something of which they have total knowledge. If you have something to sell, would you sell it at a time when its price is high or when you are pretty sure you’re not going to get a fair deal? Of course you’d choose an opportune time. Companies are no different.
Consider the data graphed in Figure 16-1. In a comprehensive survey of IPOs executed over more than four decades, Professor Jay R. Ritter at the University of Florida found that IPOs underperformed already outstanding stocks of equivalently capitalized firms by 3.4% annually over the following five years. When equivalent book value was added as a requirement for comparison, IPOs underperformed by 2.1% annually.
Fees that reduce value
When stock is issued via an IPO, net of fees to the investment banker, the money spent buying new shares goes into the corporate balance sheet. Money spent to buy outstanding shares goes to former holders of those shares.
Despite reduced costs of office work and communications, high investment banking fees have stuck. For every dollar you spend for new stock, the firm issuing the stock gets perhaps 93 to 97 cents. Of course, shares sold by current holders in an IPO generate no new funds for the company. You are rewarding investment bankers and insiders at a price they set. You are not effectively funding operations of some new discovery.
Fees that provide evil intentions
IPO fees are so lucrative they provide incentive for deals not warranted by the issuing company’s goals and interests. Many IPOs are simply the result of fee-greedy investment bankers bribing company officials with huge stakes and payouts, all funded by new investors. Further, IPO fees are vastly greater than brokerage commissions. During the period that IPO shares are being marketed, brokers earn far more serving the interests of their investment banking clients than they do serving your interest.
Unfavorably lopsided share allotments
During their respective IPOs, most orders for Google were allotted fewer shares than requested while almost everyone who ordered Facebook got every share asked for. Of course, Google skyrocketed and Facebook plummeted over the next few months. The allocation was not a coincidence or a mistake. If a deal is “hot”, as in the case of Google, favored clients and insiders will get preferential treatment and receive the lion’s share of allotments. Regular folk like you will be left out in the cold, perhaps getting a fraction of what you ask for, if any. If a deal is not well received, perhaps doomed for quick decline, the general public will be unaware while insiders and institutions will be warned. In these situations regular investors like you will get every share requested.
What you should do instead
Unless you are an insider who can legally discern tangibly positive relative value in a new issue, you should avoid the IPO market. If you like the nature of the IPO issuing firm’s business, consider a low expense index exchange traded fund that focuses on that industry. If you are intrigued by the specific details of that company, continue to follow it after the initial shares are placed. Investors who bought Google (or IBM, or Apple, or Facebook) weeks, months and even years after the IPO did very well.
* Data source: Professor Jay R. Ritter, University of Florida, “Returns on IPOs during the five years after issuing, for IPOs from 1970-2013”, 2014.