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Benefits and Risks of Investing in IPOs

In 2014 to date, we have seen almost 200 IPOs in the US, around a 50% increase on 2013. Equally, here in the UK, we saw 86 IPOs in Q1 and Q2 of 2014, a significant increase on 2013.

IPOs almost always hit the headlines, especially when the share price rockets or dramatically falls.

Who doesn’t remember the Royal Mail initial offering last year where the share price increased by over 48% from their IPO price on the first day of trading? Or Twitter, whose shares opened a whopping 73% above their IPO price?

However, are these just one-offs, or do IPOs represent a good investment opportunity? We look at some benefits and risks of IPOs below and conclude that maybe this represents a good (albeit high risk) investment opportunity.

 

Benefit 1: Results of IPOs

Luckily for us, Jay R. Ritter of the University of Florida has already done a lot of the number crunching in an academic report released on May 9, 2014. His paper looks at historical first-day returns on IPOs in the US markets since 1960.

The following shows the first day returns of IPOs with an IPO price of over $8 (this is to remove the VERY high variance penny stocks). The data is probably best summarized by this table:

This shows us that the average return on the first day of an IPO is an increase of almost 17%. This is a pretty impressive return for one single day. In fact, this is pretty darn crazy!

In 2013, there were 161 IPOs in the US with IPO price of over $5.

Let’s make a couple of assumptions (which will not be realistic, but helps us understand the potential benefit of these increases):

• You have $100k available to invest at the start of the year, meaning that you can invest $10k in all of the IPOs in the year (even those running concurrently);
• You have access to the IPO price for all 161 IPOs (see risk 1 below);
• You sell at the “first day return price” for each IPO;
• The average first-day return is 16.9% (in reality it was 22.3% in 2013); and
• Your $10k is invested across 10 IPOs and then each $10k chunk is reinvested 16 times each.

If you were able to do this, and you reinvested the full proceeds each time, you would grow your $100k to $1.2m within the year.

Unfortunately, due to the risks noted below, this probably won’t be an option in reality. Shame. However, it is important to realize that if you can obtain the IPO price, then the returns can be pretty positive in the very short-term.

 

 

Benefit 2: Being selective in our choices

Another benefit of IPOs is that we are not forced to participate in any particular ones. We can try to pick & choose the IPO based on the company, their published accounts and the mood of the market at the time. This could enable the skillful investor to further improve their performance compared to the average figures highlighted above.

There are many tools to try to understand the possible opening price of the shares before they are actually released to the market.

For example, in the upcoming Alibaba IPO (expected to be the largest amount of capital ever raised from an IPO), you can follow the “IG grey market” which indicates the expected future value of the company.

If you can use these tools effectively, you can effectively choose the IPOs which you believe will have a first-day closing price above the IPO price and therefore profit rapidly.

 

Benefit 3: Using IPOs to understand the wider market

This is not necessarily a benefit of investing in IPOs. However, the IPO data does appear to be a good indicator of future market performance.

For example: in the academic study highlighted above, the fraction of IPOs with negative earnings for smaller share offerings (initial price below $5), can often tell us something about the market becoming over-heated.

Looking at the dotcom bubble years (1999-2000), we can see that the one day performance of negative EPS IPOs went a bit crazy, with the return on negative EPS IPOs outperforming their positive EPS counterparts by about 80%, and average one day gains hitting over 70% for negative EPS offerings.

In recent years, there has been some discussion about the new wave of technology IPOs and whether we are approaching a similar bubble.

This data does show some worrying signs, but not necessarily to the same extent as 1999/2000.

For example, in 2011 & 2012, the percentage of all IPOs which were tech stocks was 44% and 42% respectively. The only time these were higher were in 1999 and 2000 (which was followed by a 40% fall in the S&P in the following 3 years) and in 2007 (which was followed by a 38% one year fall).

Equally concerning for any bears is the fact that in 2013, 64% of IPOs in this sample were from companies with negative EPS. Again, this was only higher in 1999 and 2000.

Therefore, whilst we do not necessarily advocate trying to time the market, if you are insisting on doing so, using IPO performance data may be one of the better ways to determine when the market is become heated due to over enthusiasm.

 

Risk 1: Not being able to obtain the IPO price

This is the key problem with IPOs.

In our above examples, we measured the performance of IPOs as being the difference between the closing price after the first day of trading and the “IPO Price”. When referring to the IPO price, we are speaking of the launch price which is available to investors before the company trades on the open market.

However, IPOs are not always open to the retail investors, and so this price is often not available.

Let’s take a look at the last year in the UK for example. There have been 86 FTSE IPOs in the past year. Say I traded with iii.co.uk in the UK, as a retail investor I have only had the opportunity to invest in the following 11 IPOs. This is a very small fraction of the total.

So, whilst my returns have still been pretty impressive (9.9% daily return – although this is more like a monthly return as your capital is tied up for a period of time), they significantly underperform the averages noted above as not all IPOs are available to the general public (“the retail investor”).

This is because the best IPOs will be snapped up immediately by the large institutional investors (mutual funds, pension funds, big banks, etc) and hence the little man on the street is left with “the dregs”. That said, those dregs may still be pretty appetizing at 9.9% return over such a short period of time.

 

 

Risk 2: Variance / Risk

The second risk with IPOs is, well, risk!

As you can see from the results above, the share price can wildly fluctuate in the first few days of trading.

Therefore, you have to be happy to lose 30% in one day on a certain IPO, and expect to gain the same on another. With this level of variance, investing in IPOs isn’t for the light hearted.

 

Conclusion

I’ve always considered IPOs a dangerous place to play. However, averages of 9.9% returns on those shares available to retail investors (which could be realized in between one week and one month) deem the annual returns of IPOs a fairly attractive proposition.

Of course, fees and variance will play their part, as will tax implications, and you should never buy an IPO on the first day of trading on the open market (the gains are already built in by this point).

However, if you can be part of the initial offering, it would appear that there are fairly substantial profits to be made by investing in IPOs.

As a “real-life” test, I am going to place £1,000 in each of the upcoming IPOs available with my broker, with a rule to always sell on the first day of trading no matter what the outcome. Its very important to stick to this rule given the analysis above. One may be tempted to hold onto an IPO which falls 20% on the first day in the hope that it bounces back (like Facebook famously did). However, this is not true for the majority of shares, and hence I shall strictly follow this first day sell rule. All profits will then be reinvested into the next IPO and so on. Come back to see my in about a year or so and I’ll let you know how I got on…!

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