Asad Gourani, CFP®
Should I Invest in IPOs?
Updated: Jan 18, 2021
2019 has had no shortage of financial hype when it comes to initial public offerings. There is a plethora of speculation and discussion around any major IPO, but this year, major, staple companies such as Lyft, Uber, Pinterest, Levi’s and more have gone public. Investment experts opinions were mixed when it came to investing in certain companies even before they went public, such as Lyft, which stood in the shadow of Uber as a competitor, and on the other hand there are certainly some IPOs, such as Beyond Meat and Zoom, have done extremely well.
Does that mean it is something you should get into? Let’s examine.
There are several reasons why a company would make the decision to go public via an IPO. Some of the main reasons include raising capital from investors to expand or operate the business, or to create a liquidity event for founders and venture capitalists so that they can cash out part of their investment. IPOs are more likely to occur in a bull market when investors are optimistic; as the old saying goes, “raise capital when it’s available, not when you need it.”
When prices are rising in this type of market environment, companies can maximize the amount of money they can raise. Newly public companies may use these funds to fund capital expenditure, provide additional research & development, or pay off existing debts. Choosing to go public can help a company’s financial future as well. The media hype surrounding an IPO increases a company’s brand awareness, helping consumers to become more familiar with the company and more likely to purchase its products or services in the future. Yet, many base initial investments after an IPO on speculation rather than true awareness.
However, going public can present a unique set of challenges for the company involved. If the company is newer, the demands of frequently required reporting can prove to be a big undertaking. The new pressure of the market seems to cause companies to focus on whatever affects their stock price rather than focusing on the future, and we see that with older companies who would rather buy back shares and hit short term earnings numbers rather than investing in longer-term projects that could potentially add new streams of revenue or the most recent trend within newer companies which is growth at all cost without regard to profitability.
An alarming trend
Today, it’s not unreasonable to say the markets are seeing some similarities between companies now going public versus the tech bubble days of the late 1990s, although the two time periods are far from a perfect comparison by any metric, given the size and quality of the companies today. Valuations now are not perfect, but they are doing far better than before. In the 90s, tech companies were able to go public with no earnings, no sales, and no tangible assets. In 2018, 81% of companies that went public had negative earnings. 2019 has seen another big wave of IPOs, and both corporations and venture capitalists alike express perhaps unwarranted optimism.
What’s In it for you? There’s undeniably a number of IPOs that have done well over the years, and chances are there will always be something that will do well in the future, but investors have to keep in mind that in general the odds are stacked against them. As Ben Graham says in his book the intelligent investor IPO stands for “[I]t’s [P]robably [O]verpriced” when companies want to raise capital they will try to maximize what they can get which means the investor is already at a disadvantage, adding to the fact that when these companies go public you just don’t have a detailed record of their financials which makes it difficult to make an investment decision.
Investment research has shown that the average investor is more likely to be successful by investing in existing companies or funds rather than trying to beat the market by investing in an IPO and its uncertainty. For investors, conventional financial wisdom argues that it is most effective to buy low and sell high. This means buying the stock of a company when it is undervalued. When a company initially goes public, however, the company’s management does its best to increase interest in purchasing the stock and increasing the valuation. Therefore, investors may not be getting the best possible price.
Forget the hype, and focus on staying well-diversified.