Are IPOs Good Investments?

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Includes: IPO
by: Blake Morgan

Summary

IPO Data From 1980-2014 Shows Significant Underperformance of IPOs.

IPOs Underperform Similarly-Sized Companies Already Listed.

Why are IPOs Underperforming?

IPOs, short for Initial Public Offerings, generate a lot of buzz and excitement. When Alibaba Holdings Group (NYSE:BABA) went public, it was the largest IPO in history. The Chinese company went public on September 18, 2014 for an eye-watering $21.8 billion. Every news outlet had something to say about it. People talked about it both at work and at family gatherings. Facebook (NASDAQ:FB) also generated quite a bit of hype. The idea of owning a piece of the social media you use every day was quite an enticing proposition. Looking beyond the hype, have IPOs been good investments over the years? What do the facts actually say?

IPOs Underperform Substantially

As much as I hate to burst everyone's bubble - investing in IPOs is statistically a bad idea. As I will make painfully clear in this article, unless you can tell the future, investments in IPOs will result in lower returns. Let's take a look at the data compiled by Jay R. Ritter at the University of Florida, Warrington College of Business. The sample size of this data is vast, utilizing 8,061 IPOs from 1980 to 2014.

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Let me explain the data above. Ritter compared the performance of IPOs over three years to previously listed companies. In the size-matched category, Ritter compared the performance of the IPO to the CRSP value-weighted index of Amex, Nasdaq, and NYSE firms. For the style category, "a non-IPO matching firm that has been CRSP-listed for at least five years with the closest market capitalization (SIZE) and book-to-market ratio as the IPO is used." (Ritter 2016) The result is a staggering difference in return. From 1980 to 2014, investing in IPOs resulted in a difference of -17.8% over three years compared to market-adjusted returns and -6.3% compared to style adjusted returns. While your return still would have been positive at 22.1% over three years, your returns while buying similarly sized companies that were already listed would have yielded much higher returns. You may point out that from 2001-2014 the IPO performance outperformed the market adjusted return and in 1980 to 1989 the IPO strategy outperformed the style adjusted return. While these are small periods of outperformance compared to the total data, they warrant further research. So let's take a look at five-year returns.

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In his five-year data, Ritter takes a slightly different approach in his comparisons. For the size-matched returns, each IPO is matched with the non-issuing firm having the same or next higher market capitalization (using the closing market price on the first day of trading for the IPO, and the market capitalization at the end of the previous month for the matching firms). For the size & BM-matched returns, each IPO with a book-to-market ratio higher than zero is matched with a non-issuing firm in the same size decile (using NYSE firms only for determining the decile breakpoints) having the closest book-to-market ratio. (Ritter 2016) This will provide data for those who wish to compare companies with similar book-to-market ratios. The end conclusion, however, is the same. IPOs once again underperform given all the data we have. IPOs had a geometric mean return of 10.9% vs. size-matched companies which provided a 13.9% return. When book-to-market was taken into account, the difference was smaller but IPOs still solidly underperformed. Book-to-market IPOs had a geometric mean return of 12.7% compared to IPOs' 10.8% geometric mean return. Again, even over a longer period of time, IPO investments statistically underperformed similar companies already on the market.

For those of you still wondering about the two periods of IPO performance I alluded to earlier, let's take a look at the five-year return data for those time periods.

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Once we utilize five-year data, the IPO outperformance disappears in the 1980-1989 time period. IPO firms had a geometric mean return of 7.1% over five years while size-matched companies had an 11.4% geometric mean return. When matched to size and book-to-market companies, IPOs had a geometric mean return of 6.9% compared to a 7.9% geometric mean return for the similar book-to-market companies.

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The same situation appears in the 2000-2014 data. IPO firms had a geometric mean return of 8.3% over five years while size-matched companies had a 9.2% geometric mean return. When matched to size and book-to-market companies, IPOs had a geometric mean return of 8.1% compared to a 10.6% geometric mean return for the similar book-to-market companies.

The conclusion is fairly clear - IPOs are not good investments based on past performance of IPOs. So why do IPOs underperform? Perhaps because IPOs are more and more frequently coming to the market with negative earnings.

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As we can see from the above chart, in 2014 and 2015 the number of IPOs with negative earnings surpassed 70%. In the 1980s, this number hovered around 20% and often dipped below 20%. The number of companies coming to the public markets with promises instead of profits has been increasing rapidly. This shows that people are more willing to pay for shares in companies with negative earnings. As we have seen from the data though, hype isn't a good investment strategy.

I will depart with one final chart from India to show the growth of RS 100 invested in IPOs vs. similar previously-listed companies. As we can see, this is not a phenomenon unique to the United States so don't go hoping that overseas IPOs will be different. Hopefully this article will help reduce the hype for new IPOs and generate some skepticism.

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.