Through September 6, 2021, traditional initial public offerings (IPOs)—which excludes speculative…sorry, special purpose acquisition companies (SPACs) and direct listings—have raised a staggering $105 billion, according to The Wall Street Journal (See article “For Allbirds, Warby Parker, Other Fall IPOs, Greed Is Out. Do-Gooding Is In”). In case you are looking for context, it is a number that approaches the full-year totals achieved during the tech boom of the late 1990s. About 20 IPOs a week have priced on average. In some weeks, however, that number has more than doubled.
As if the market for IPOs was not hot enough, some of Wall Street’s biggest banks, anxious to get in on the action, have the itchy trigger-fingers of a classic western movie. A few big names are teaming up to usher the IPO market into the 21st century, including Fidelity Investments, Goldman Sachs Group, J.P. Morgan Chase & Co, among others. This cabal of IPO hawkers have lent their backing to Capital Markets Gateway LLC (CMG), a technology platform that currently provides data and analytics on follow-on stock sales, block trades and IPOs, as well as list of the underwriters for each offering. With the help of its backers, CMG will expand its offering, enabling investors to submit orders for IPOs and other equity-capital-market deals on a computer rather than utilizing “old-fashioned” methods (i.e., verbally over-the-phone). The expanded platform is set to launch later this year.
It doesn’t take a genius to conclude that IPOs are big business for Wall Street. And why shouldn’t they be, given their profitable nature…for insiders. Much like their SPAC cousin, IPOs generate large sums for its underwriters, promoters, sponsors, early insiders, etc., who often benefit from exorbitant advisory and other fees (oftentimes, of upwards of $100 million), as well as cheap shares that are cashed out at inflated values when a company goes public. How barely profitable and, in many cases, unprofitable companies are slapped with such astronomical valuations is one of the great machinations of Wall Street. It proceeds in this manner: successive firms assign higher and higher unjustified valuations on a company—whether they believe in its long-term prospects or not or have discovered information that belies those prospects—with the sole objective of generating five- or ten-fold profits upon said company’s initial public offering. Enter small, or average, investors.
Believing in the savvy valuation hype of Wall Street and the first-day trading of select institutions positioning themselves for subsequent gains (technology IPOs, for example, jumped 34% on average on their first day of trading in 2020), many small investors feel compelled to get in on the action, lest they experience FOMO (fear of missing out). This leads to a further run-up in an IPOs share price which, in turn, causes more small investors to experience FOMO and, thus, leading to an even higher share price in subsequent days and weeks. And if you do not believe in the power of small investors to ratchet up a share price to ridiculously high levels, then you have obviously never heard of “meme” stocks.
Soon, realizing the playbook has once again been successful, the “smart money” (i.e., Wall Street) heads for the tunnels, exiting the game, as the traditional six-month “lockup” period has been steadily eased for insiders wanting to sell following an IPO. What is left is the opposing team of small investors standing on the field beaten and broken, wondering how the game got away from them. Sadly, they have once again lost the game of “Who Will Get Stuck Holding A Bag of Near-Worthless Securities”.
Unfortunately, the above scenario is not only common but has been the hallmark of IPOs, which have a history of turning out to be bad investments for small investors. The famed Jeremy Siegel conducted a study (2003) that examined the IPO returns of nearly 9,000 stocks that went public since 1968. The conclusion: on average, such issues underperformed the market by 2-3 percentage points per year, with 4 out of 5 underperforming a small cap index, in many cases by as much as 30% per year. And while Mr. Siegel has suggested IPO share prices have performed a little bit better over the last 20 years, the gains mostly accrued to the well-connected who were able to get in prior to, or on, the first day of trading.
Professor Jay Ritter (University of Florida), whose research has been cited in the Wall Street Journal, has arrived at the same conclusion, based on studies of the IPO market spanning the 1990s and 2000s. Ritter found that, on average, IPOs underperformed similarly sized companies by 3.4% percent per year during its first five years of trading. Ritter also echoed Siegel’s caveat that first-day return performance typically benefitted only large institutional investors.
As if this is not enough, no less than Warren Buffett has advised small investors against investing in IPOs, citing the asymmetry of information that precludes small investors from competing with better-informed institutional investors and large investment banks.
“It’s almost a mathematical impossibility to imagine that, out of thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller [company insiders] to a less-knowledgeable buyer [investors].” (Warren Buffet)
In conclusion, the results are in: unless you are an insider or otherwise well-connected, it is far better for small investors to steer clear of IPOs. Yes, yes…I understand very well how tempting of a proposition it can be. Yet, as one writer noted, most of the wealthy people in the world did not become so by investing in a “hot” IPO that shot up 600 percent in one day.