Initial Public Offerings: Should You Invest In Them?

For the uninitiated, an initial public offering (IPO) is a process whereby a private company offers its shares to the public for the very first time. Once the company become listed, its shares are traded on the stock market. 

Many investors love investing IPOs for many reasons.

They might have heard about their friends making some kopi money by betting on the latest IPO, and they want in.

While for some others, they might apply for IPOs due to FOMO (fear of missing out). They fear that if they do not put at least some money in the company that is going public, they could miss the boat and not get a great investment opportunity again.

So, are IPOs really that great and would you miss out if you don’t get in early?

TL;DR: Is It Wise To Invest In IPOs?

• Data shows that most IPOs tend to underperform after some time from going public
• IPOs are usually sold at prices far higher than the value of the underlying businesses

Poor Performance Of Singapore IPOs In 2018 And 2019

Using data from SGX, I wanted to find out if people would have made money from IPOs or are they better off not applying for them.

In 2018 and so far in 2019, 26 companies went public. Of them, more than half ended their first trading days in the positive region. However, as time went on, those companies gave up on their losses and are now selling below their respective IPO prices.

The statistics from the table below is telling:

Source: SGX; author’s computation (data as of 12 November 2019)

Of the 26 IPOs, 54% were in the green on their debut days, but 31% of them went underwater many days after their IPO.

A quick glance at SGX’s website on the past performance of IPOs since 2012 gels well with the statistics above.

So, when it comes to probability, the odds of making money for the long-term by buying IPOs is low. Investors are better off being patient and investing in the companies after they have gone public. These companies would have also survived the scrutiny of the public eye. 

Highly Valued

There are many reasons companies list on a stock exchange. Companies go public mainly to raise cash from new investors, that is, you and me.

Another reason is for current investors, such as the founders, private equity firms, and large individual investors, to “cash-out” a part of what they have invested.

With that in mind, there’s almost zero chance for IPOs to be sold at undervalued prices. IPOs are usually sold at prices far higher than the value of the underlying businesses. In doing so, key stakeholders of the company going public can get maximum returns. 

Generosity is a rare occurrence in the IPO market.

Ordinary Folks Lose Out

I came across some note-worthy quotes by two stock market professionals that I thought were worth sharing.

One is by Warren Buffett, who has produced a commendable return of around 21% yearly for the past 50-odd years, and the other is by Professor Sanjay Bakshi, an adjunct professor at Management Development Institute, Gurgaon, India. 

Warren Buffett, is his 1993 letter to shareholders, wrote (emphases mine):

“[An] intelligent investor in common stocks will do better in the secondary market than he will do buying new issues… [IPO] market is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavourable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of public offering or in a negotiated transaction.”

Professor Sanjay Bakshi, in his article entitled The Economics of IPO (and other) Markets, wrote (emphases are mine): 

“Four characteristics of the IPO market makes it a market where it is far more profitable to be a seller than to be a buyer. First, in the IPO market, there are many buyers and a only a handful of sellers. Second, the sellers, being insiders, always know more about the company whose shares are to be sold, than the buyers. Third, the sellers hold an extremely valuable option of deciding the timing of the sale. Naturally, they would choose to sell only when they get high prices for the shares. Finally, the quantity of shares being offered is flexible and can be “managed” by the merchant bankers to attain the optimum price from the sellers’ viewpoint.”

He added (emphases are mine):

“But, what is “optimum” from the sellers’ viewpoint is not the “optimum” from the buyers’ viewpoint. This is an important point to note: Companies want to raise capital at the lowest possible cost, which from their viewpoint means issuance of shares at high prices. That is why bull markets are always accompanied by an surge in the issuance of shares.” 

The table we saw earlier indeed shows that investors are better off investing in stocks in the secondary market (or in the stock market once the company goes public) and not on the primary market, as is the case with IPOs. 

Companies generally list when the stock market is doing well, as that means demand for shares would be high. On the flip side, there have also been instances where IPOs were called off as market sentiments were not that great. Without buoyant market sentiments, IPOs tend to perform poorly on their debut days. 

Sanity Check

In my opinion, investors should not buy into IPOs based on market sentiments and hype alone. IPOs are certainly not a “sure win” thing, and there’s a high chance we can buy shares in the company below its IPO price sometime later, as shown from the data above.

If investors really wish to invest in an IPO, they should understand the business thoroughly and analyse whether the valuation of the IPO makes sense before applying for it.

The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. ​Readers should always do their own due diligence and consider their financial goals before investing in any stock.