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 Market Mysteries of the week

  Is it a good idea to invest in companies right after their IPO?

Answer:

It's very risky.

It might be better to wait and watch the stock for a bit.

What is an IPO?

An Initial Public Offering (IPO), aka "going public," refers to

the first time a company asks us regular people to invest

. Before that, you had to know somebody or have a ton of money to get behind the red rope. They sell shares of their company to the open market in exchange for our cash.

Companies can use that cash for all sorts of things like expanding their business operations

. 

Going public also

makes it easier for any previous investor or early employee to cash out.

They can now sell their shares in the company on the open market through a regular brokerage account online instead of structuring individual private deals with extensive legal documentation.

How do you participate?

There's a little behind-the-scenes action happening

before the stock goes entirely free

on the market. Companies hire Wall Street investment banks to help them with their IPO. The investment banks analyze and value the company, figuring out what people might be willing to pay for its stock. Then, the bank finds initial buyers for the stock, gauging investor interest among institutions and private clients. On the morning of the big day, the banks distribute the shares to the buyers at the initial price, and then open trading kicks off. After that, anyone can buy and sell the shares freely.

Is it better to get in early?

Not always.

The first day or two of

trading will typically be highly volatile

. That volatility tends to die down after a few days, but new stocks tend to remain unpredictable for the first year or two.

Last year was an excellent year for IPO's

. It was an excellent year for all risky investments. The average

first-day return for newly-public stocks in 2020 was nearly +42

%. That was the best year since the dot-com boom and bust of 2000. 

Most newly-public stocks will underperform

the market in their first several years. From 1985 to 2019,

the median 4-year return for stocks bought on their IPO day was -17%

. Nearly 57% of IPO's over those 35 years

had negative returns over four years

. 

Why is it so volatile?

They're volatile because they're new.

It's not easy to put a price on something new. There's less information to build on. Investors need time to work through their opinions on the company. There will be people with very low confidence in the company and some willing to pay a high price. Investors gradually make up their minds on how the company might grow and perform relative to other companies, so the price starts to settle between optimists and pessimists. 

One crucial thing to consider about newly-public companies is the

potential lock-up periods.

Often,

employees and private investors with existing shares in the company are legally restricted from selling

their shares for some period of time as great as two years. That creates a big pool of investors and employees waiting to cash out until the lock-up period is over. Once the restriction lifts, there might be a big wave of selling that could push the stock price down. 

Be extra cautious around IPO's.

We'll start small when we want to invest in a particular company but have concerns about the timing. We can buy a single share and watch it, maybe even set price alerts. If we see the price fall for no reason that shakes our belief in the company, we buy more.

Please share this with anyone who might find it helpful!

💙 The Share Scoops Team

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