No event in financial markets seems to get investors (institutional and retail), stockbrokers, bankers and journalists excited in the same way as a new initial public offering (“IPO”). The announcement of a new IPO is always greeted by a frenzy of analysis and commentary, with the prospectus being poured-over in detail and much being discussed about the offer price. I however, take a different approach – I completely ignore IPOs. Why? Because research shows that investing in IPOs is likely to significantly impair the long-run performance of your equity portfolio.
In “Hot IPOs Can Damage your Long-Run Wealth!” Jerry Coakley, Leon Hadass and Andrew Wood of the University of Essex find that in the five years following the offering date, UK IPOs underperform the FTSE All-Share Index by a cumulative 4.55%. In “hot” IPO markets, this five-year cumulative underperformance increases to 35.7%. A “hot” IPO market is defined as one which satisfies two of the following three criteria: (1) abnormally high IPO volume; (2) abnormally high initial returns; and (3) non-negative autocorrelation in IPO volume. Empirical evidence of IPO underperformance has been found in a number of long-term studies, as highlighted by Paul Schultz (University of Notre Dame) in “Pseudo Market Timing and the Long-Run Underperformance of IPOs”.
This evidence raises the question of why IPOs systematically underperform the rest of the market. The research on this matter is not 100% conclusive though many reasons have been put forward by academics. Many of the reasons relate to the privileged position of existing shareholders and the directors to control all aspects of the process, which works to the detriment of investors. The first reason relates to IPO timing. There is significant evidence to suggest that companies utilise asymmetric information (ie. the superior knowledge of management regarding the company’s prospects) to time IPO transactions to coincide with: over/highly-valued stock markets; cyclical peaks in company profits/likely-valuations; and/or at a time preceding possible (negative) structural change for the company. Empirical research shows that this risk is magnified when directors/shareholders are selling their own shares as opposed to the company raising new capital by diluting existing stockholders – a clear positive correlation exists between the dilution of existing shareholders (at IPO) and the subsequent total shareholder return. A further factor that allows existing shareholders to tilt the process in their favour is control over the financial statements. At least one academic study finds that one cause of disappointing post-IPO performance is pre-issue earnings management – ie. company’s engage in aggressive “window-dressing” prior to issuing stock in order to maximise the offering price.
It is not just the actions of management prior to IPO that make such transactions bad investments – investors themselves are also to blame. Because of their nature as younger companies seeking capital, and/or entrepreneurs cashing-in on their wealth, IPOs are often (but not always) companies in relatively new, growth industries. As significant research has shown, investors tend to overpay for the expectation of profit growth from relatively new “glamour” industries. This also holds true in IPOs, with one study suggesting that IPO investors overpay by around 75% on average based on comparing expected growth implied in the IPO price with realised growth.
There are also other reasons why IPOs tend to underperform. One study has found that managers of firms that IPO are too optimistic about company prospects in the years after flotation, causing them to avoid further capital raisings that could have been used to invest in positive-NPV projects. Another study has found that this same optimism leads to over-aggressive acquisition strategies, leading IPO-companies to overpay for targets and destroying value in the process.
In summary, although it is possible that the current hot IPO may be “the next Microsoft/Google/Apple” [delete as applicable], IPOs in general tend to underperform because: insiders benefit from information asymmetry which allows them to time the IPO to their advantage and off-load their stock; investors are overly-optimistic in their expectations of earnings growth; directors engage in earnings management prior to the IPO in order to maximise the offer price; overly-optimistic managers fail to see the benefit of raising further capital for investment; and because post-IPO firms are more likely to engage in value-destructive acquisitions. Cautious Bull therefore keeps well away from “hot” new issues.
“The Post Issue Operating Performance of IPO firms”, Bharat Jain and Omesh Kini
“On the Long-Run Performance of IPOs”, Arif Khurshed, Ram Mudambi and Marc Goergen
“Growth to Value: A Difficult Journey for IPOs and Concentrated Industries”, Gerard Hoberg and Lily Qi
“The Desire to Acquire and IPO Long-Run Underperformance”, James C. Brau, Robert B. Couch and Ninon K. Sutton
“Does Managerial Optimism Lead to Long-Run Underperformance? Evidence from Venture Capital-Backed IPOs”, Jean-Sébastien Michel
“The Long-term Underperformance of Stock Offerings: Evidence from China”, Ouyang Liangyi and Maurice K.S. Tse
“IPO pricing: growth rates implied in offer prices”, Giordano Cogliati, Stefano Paleari and Silvio Vismara