Initial public offerings (IPOs) are the first time that stock from a privately held company becomes available to the public. With big-name companies making initial public offerings this year, many investors are clamoring for an opportunity to strike rich and get in as soon as they can. However, history shows us that investing in those initial offerings doesn’t usually yield the desired results. This is why investors should consider not buy into IPOs.
IPOs Underperform Indexes Historically
There are multiple players involved with bringing a company public. One critical player is the underwriting bank, which determines the IPO offering price and can control who can acquire stock at that price. Many of the outsized returns associated with an IPO are seen in the first trading day because initial trading prices are typically higher than the IPO offering price.
Since many investors won’t receive the IPO offering price unless they are a high-net-worth client at the underwriting bank, a corporate insider, or an employee being granted stock or stock options, let’s focus on IPO performance after that first trading day, also known as the secondary market.
Dimensional Fund Advisors ran an analysis on first-year performance of IPOs compared with the 3000 larges companies in the United States (the Russell 3000) from 1992 to 2018. During that period, the Russell 3000 outperformed IPOs by 2.2%.
Modern IPO data by Jay Ritter, Director of the IPO Initiative, also shows this trend is consistent over 3-year periods as well. Expected average Russell 3000 outperformance ranges from 2-2.5% over time.
Banks And Corporate Insiders Will Time The Offering To Public Buyers’ Detriment
Oftentimes, major IPOs are clustered in periods of high economic optimism or sector-specific hype. In the late 90’s, it was all about the internet. In 2021, much of the optimism was around electric vehicles. Right now, companies focused on AI are receiving massive valuations.
When the market is hot, that usually comes with a high price tag and banks and corporate insiders know that. They will try to time an offer to make the most profit for the lowest cost of capital.
Insiders And Institutional Players Know More Than You
Earlier, I mentioned how banks control the availability of an IPO at the offering price. Corporate insiders and institutional players traditionally get first pick of IPOs. In the academic paper, Venture Capital and IPO Lockup Expiration, data shows that for IPOs that perform well, there is slim if any availability of that offering to the general public.
That means that those major players reviewed their available data and decided to buy up everything available without the public gaining access. IPOs that do have widely available stock to the public historically underperform, meaning that those insiders and institutional players passed on an opportunity to buy before the stock was in the secondary market.
Newly Public Companies Often Mishandle The Inflow Of New Capital
Once a newly public company has an influx of cash from the IPO, there is no guarantee that the company will spend it wisely. In fact, a Journal of Financial Research article titled IPO Proceeds Deployment and Firm Performance, finds that firms often make unwise decisions, including over-expanding their operations, making unprofitable acquisitions, and rushing to build an empire without sustained growth to back up the spending.
Conclusion
IPOs may offer excitement and early headlines, but the data is clear: most investors cannot access the best prices and, over time, IPOs tend to lag the broader market. Between structural disadvantages, insider advantages, and inconsistent capital allocation, IPO investing is often more speculation than strategy. For long-term success, investors are generally better off staying diversified and avoiding the IPO hype cycle.
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Cicely Jones (CA Insurance Lic. #: 0K81625) offers securities through Equitable Advisors, LLC (NY, NY 212-314-4600), member FINRA, SIPC (Equitable Financial Advisors in MI & TN) and offers annuity and insurance products through Equitable Network, LLC, which conducts business in California as Equitable Network Insurance Agency of California, LLC). Financial Professionals may transact business and/or respond to inquiries only in state(s) in which they are properly qualified. Any compensation that Ms. Jones may receive for the publication of this article is earned separate from, and entirely outside of her capacities with, Equitable Advisors, LLC and Equitable Network, LLC (Equitable Network Insurance Agency of California, LLC). AGE-8974783.1 (6/26)(exp. 6/30)