DON’T ALWAYS BELIEVE THE HYPE ABOUT LISTINGS
▶ Initial public offerings can deliver large returns but experts urge investors to tread carefully, writes Stian Overdahl
Initial public offerings are the cornerstone of modern equity markets, and investors buying the right company after it lists can position a portfolio for significant growth – if they are patient.
But IPOs are often held up for their expected quick gains. Shares in a company can rise well above its subscription price once they begin trading, providing a pop, and may even continue to gain, delivering additional windfall to investors.
However, IPOs can also flop when the price sinks below its listing price – even if the underwriters are furiously buying shares in an effort to support it.
Lately, IPOs have been on a roll. Last year, there were 407 IPOs in US markets, a level not reached since the dotcom bubble from 1999 to 2000.
That momentum has carried on into this year and there have also been high-profile listings on the London Stock Exchange and in markets in the GCC – with plenty more to come.
Michelle Lowry, a professor of finance at Drexel University in Philadelphia and a longtime observer of IPO markets, describes the current level of activity in the US markets as “crazy”.
She sees two main contributing factors: the overall strength of the market and that many venture capitalists are under pressure to exit their positions in private companies due to the typical 10 to 12-year cycle of a venture capital fund.
With many IPOs having provided fast returns for investors, it is no surprise that ordinary investors are taking notice.
However, experts say that while investing in IPOs can sometimes be high reward, it is always high risk. Not only are you investing in new and untested companies but recently listed stocks also tend to have higher volatility and most will perform worse than the general market during a downturn.
“Investors should build up a core of investments using trackers or funds before dabbling in individual shares around the edge,” says Susannah Streeter, a senior investment and market analyst at Hargreaves Lansdown.
“Certainly do not put all your eggs in one basket, hoping to make a really quick return on an IPO.”
The first thing to know as an ordinary investor in IPOs is that in markets such as the US, you are playing in a space that tends to favour large investors.
Before a public listing, the underwriters (investment banks) allocate shares to institutional investors at the subscription price. However, once it begins to trade on an exchange, its listing price will normally be much higher. Most underwriters will strive for about 15 per cent underpricing on average, says Ms Lowry.
That means when you buy shares on an exchange on listing day, much of the pop has already taken place.
This results in starkly different outcomes: 2020 data from Reuters showed that the average return for institutional investors from IPOs in US markets that year was 75 per cent but only 28 per cent for retail investors if they bought the same shares at the end of trading on day one.
Many brokers do offer IPO subscriptions to ordinary investors, although supply may be limited or only allocated to a broker’s top customers. This typically presents better value than buying once a company lists.
However, one thing to be aware of is that when an IPO is “hot”, there is more pressure on underwriters to allocate shares to institutions over retail investors.
When ordinary investors can secure large allocations, it may be due to weaker demand from institutions, meaning the listing may go poorly.
Direct listings are an alternative, where shares are sold to all investors on an exchange when it lists. Some recent examples include Spotify, Asana, Palantir and Coinbase. This can provide a more level playing field as “all investors get a bite of the cherry at the same time”, says Ms Streeter.
However, direct listings can be equally volatile: Coinbase, the cryptocurrency exchange, listed at $381a share but dropped to about $200 in subsequent weeks.
Hype and media attention play a big role in IPOs. An opening day pop is good marketing, especially for consumer brands. Volatility draws in day traders looking to ride momentum, with opening day pops often extending into rallies that last several days or weeks. But investors need to have their guard up. For instance, postIPO price action is no guarantee of long-term growth.
As a cautionary tale, consumer action camera maker GoPro’s stock made its stock exchange debut at $31 a share in 2015, rose to about $100, then entered a sustained slump that dragged its price below $3. It recently traded at $11 a share.
To identify companies with positive long-term prospects, investors need to focus on their fundamentals, especially expected earnings growth.
They should treat a newly listed company as any other and apply the same analysis, says Alex Gemici, chief executive and chairman of Greenstone Equity Partners.
Often, hype around a company will be punctured when it reports its first quarterly earnings after it lists, he says.
Investors should also pay close attention to material adverse events – the main risks a company is facing – listed in its prospectus and assess whether any may have a serious effect, says Ms Streeter.
Looking to competitors and assessing how they have coped with similar risks once they have crystallised can yield insights, she says.
There may be obvious red flags before a listing.
Deliveroo’s recent flop in March points to the increasing prominence of environment, social and governance factors.
The food delivery platform’s reliance on gig economy workers prompted ethical concerns from some parties and also legal uncertainty.
ESG is not only a label, but can also point to serious business risks, says Ms Streeter.
Investors can also approach IPOs with a macro or sectoral lens.
“Software, cyber security, artificial intelligence, data analytics – we live in a digital age and this is the glue that holds it all together,” says Jean Jacques Sunier, senior equity manager and member of the chief investment office at Julius Baer.
However, not every company in these sectors will be a winner, he says.
“As always, only a small percentage of new companies outperform most stocks.”
Since 2019, cyber security companies have been one winner in the space while healthcare IPOs from 2020 to this year have fared less well, says Mr Sunier.
To invest in companies operating in software or biotechnology, investors should understand how such technology is changing the world.
Reading a company’s prospectus and investor presentations is a great way to glean broader knowledge of the industry it is operating in, says Mr Sunier.
The biggest influence on how a new stock performs will be the overall market trend.
“A bullish market can make even the worst IPO bullish, and a bearish market the best IPO bearish,” says Vijay Valecha, chief investment officer at Century Financial.
Even if you are convinced of a company’s long-term fundamentals, listing day may not be the best time to buy.
Many experts recommend sitting back and waiting to see where the price settles before buying. Values may dip below listing price after the initial momentum fades, especially if there is a cloud of bad news, presenting an opportunity for a canny investor.
Investors can also buy funds that place funds exclusively in IPOs, including one from Renaissance Capital with the ticker IPO, which has generated a one-year daily total return of 59.95 per cent, compared with about 40 per cent for the S&P 500.
But looking at the performance of these funds, one thing is fairly obvious: when the general market rises, funds of newly listed IPOs climb higher, whereas when the general market is going down, they fall further.
That has implications for any portfolio holding individual IPO stocks: during a downturn, these companies may perform worse than the general market.
Overall, investors need to be patient to achieve the best results, as rising stock prices will occur only if a business can grow its revenue and profits over many years.
“It is those investors who have a longer-term horizon who tend to do better, rather than those who are just switching and ditching stocks and holding them for short periods,” says Ms Streeter.