There always seems to be a relatively steady stream of IPOs ripe for investors to be taking advantage of possibly huge gains – or huge losses. IPOs are sometimes seen as attractive to investors because they can get in on nearly the ground floor of when a firm open’s its doors to the broader market. But the question is if this is generally a good thing for investors to do, invest in IPOs or don’t invest.
What is an IPO?
First, we should answer what an IPO stands for – it stands for initial public offering. An Initial Public Offering (IPO) refers to the process of offering shares of a private corporation to the public with a new stock issuing. Initial Public Offerings let firms raise capital from public investors. Generally, the change from private company into a public company lets private investors reap gains from their investment, these often include shares and option contracts for private investors. While, public investors get to purchase a small piece of the company.
What’s the benefit of investing early?
Well, the benefit of investing in an IPO for a successful company is big gains – for example if you had invested in $5,000 into Microsoft (MSFT) when it went public, you’d be looking at millions of dollars’ worth of gains – around 10.4 million. While obviously these massive gains are attractive for long term investors, the reality reflects a type of bias called survivorship bias. In fact, there’s a large body of research looking at IPOs and how profitable they are for investors. They attempt to answer just how profitable are such trades.
Research paper one – Does it pay to invest in IPOs?
Paper one is entitled “Does it pay to invest in IPOs? Evidence from the Warsaw Stock Exchange” which looks at IPOs on the Polish market between 2003 and 2011. They attempt to calculate IPO performance while taking into account transaction costs, alternative costs, and taxes. They analyzed this period because it was generally a bullish time period with one notable sharp correction in equities during 2007 and another short correction in 2011. At the height of the market in 2007 and 2011, there were more than 13.5 and 6.3 times the number of IPOs compared to 2003, respectively (The data from warsaw hints to another conclusion from other papers, that IPOs tend to happen near market highs). The total data set collected was 314 companies which conducted an IPO from 2003 – 2011.
The statistics section of the paper analyzes the returns of the stock and looks at abnormal returns within said time period. On average anything with an average return of above zero means that the IPO outperformed the market for said time period. Generally, the evidence suggests that the best strategy is to buy the stock and then sell on the same day for the best returns. The longer one holds onto an IPO the worse the returns are. The remaining graphs generally support this finding as there are positively skewed with a positive kurtosis meaning most of the returns fall closer to the mean and are generally positive for the initial day return.
Research paper two – The persistence of IPO Mispricing
Another paper that looks at IPOs and initial returns paired with long run performance is a paper called “The Persistence of IPO Mispricing and the Predictive Power of Flipping.” The paper looks at “hot” IPO markets and attempts to determine if underwriters have difficulty in valuing companies. The main results are, yes, underwriters do have difficulty valuing and often under value companies – primarily those IPOs which are harder to value due to high levels of uncertainty like in tech fields. This paper was of interest because they classified “Hot” IPOs as high variability and high returns and they also test a trading strategy for use with IPO stocks.
The paper looked at IPOs between 1988 and 1995. The dataset consisted of around 1,232 initial public offerings. A fairly sizable sample size during one a very studied time period – the time leading up to the internet bubble. In the paper, the authors breakdown the sample size into four distinct groups in order to test the strategy “Cold” IPOs which are defined with a first day opening of zero or negative returns (around 26% of IPOs). While, the remaining ones are classified as “Cool”, “hot” and “Extra-hot”. “Cool” which accounts for 35% of the data has returns of zero to less than 10% on the first day of IPO. While “hot” are returns of 10% or greater but less than 60% returns and account for 36% of the sample. And finally, “Extra-Hot” are returns above 60%.
The first notable finding here is that extra hot IPOs perform less well than cool and hot IPOs. They found that ‘cold’ IPOs fell on average 1.4% in the month following offering. Further, they found that the mean and median of one-month excess returns for cold and extra hot IPOs are negative. However, the return is positive for ‘cool’ and ‘hot’ IPOs and continues into the six month and one-year time frame – and these results were significant.
“We find that the mean and median one-month excess return for cold and extra-hot IPOs is negative while the same return is positive for cool, and hot categories. The relationship of cold and extra-hot to cool and hot IPOs continues at the six-month and one-year time frames as well. In parametric as well as non parametric statistical tests,the differences between the four groups are significant at conventional levels”
Another notable finding from this paper is the result that institutions often under price IPOs in order to profit for themselves by selling shares onto the market on the first day or over the course of the first few months:
“That is, ‘flippers’ quickly sell issues which perform worst in the future (often with the benefit of underwriter price support which minimizes their exposure to losses), and they curtail flipping activity in the best performing issues. The evidence suggests either (1) that institutional investors have superior information relative to the underwriter in the market for IPOs (since they collectively appear to know and execute a profitable trading strategy on the first day), or (2) that underwriters intentionally and strategically under- and over-price IPO ‘merchandise’ without immediate measurable penalties.”
Both papers suggest something interesting, that trading IPOs can be a sound strategy if one gets lucky enough with them. However, one looked at buying into IPOs on the first day and holding them for various periods of time and found that, on average IPOs lost during the course of the next year. However, the paper on IPO mispricing found that if investors wait a day and classify the IPO into categories that first day returns can help predict future returns. Perhaps a sound strategy is to buy into them on the first day and then watch the returns, if they are a “cold” or “extra hot” IPO, you sell out of them the following trading day. But if they are not within those return ranges, investors hold onto them.
Either way, a decent place to trade IPOs is with Robinhood. Or if you’re into longer term investing with M1 Finance is a great way to build wealth. And finally, if you’re looking for further ways to enhance returns check out our high risk and ultra-high risk newsletter.
Have you invested in IPOs before? Tell me about your experience in the comments below.
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