Initial Public Offerings
Initial public offerings (IPOs) are a stock or trust that is brought to market, often with great fanfare, to fill a (perceived or manufactured) need. Even now, after the crash of the NASDAQ bubble of 2000, the news reports occasionally trumpet a hot new offering that jumped 30% or even more on its first trading day. This leads many investors to think that the way to Get Rich Quick is to invest in the latest IPO.
Unfortunately, the reality is somewhat different. Academic research has established that IPOs return much less that the market average. In his book "Contrarian Investment Strategies: The Next Generation", David Dreman refers to a large academic study by Ritter and Loughran of 4753 IPOs from 1970 to 1990. The average annual return of these IPOs was only 3%, compared to 11.3% for the S&P 500. The median return was far worse: -39%. Only a few of the IPOs made money - and those few would have been unobtainable in quantity by the average investor. Betting heavily on IPOs is a good way to drain your portfolio.
To understand why, you must consider the process behind an IPO. A potential seller and a merchant bank (an arm of a commercial bank or brokerage house) will get together to consider an IPO. The merchant bank, which employs some very clever people, will crunch the numbers and attempt to develop a scenario that is profitable for both it and it's customer (the seller). The buyer's welfare usually isn't considered.
If the issue looks favourable, it will be brought to market at a time that favours the seller. The merchant bank - which will make a nice profit from the deal - aggressively markets the product, attempting to develop a market if none exists. A prospectus will be prepared that contains profit forecasts using assumptions that are often impossibly optimistic; this is particularly likely if retail investors, rather than institutional investors, are the desired market. After all, if it's such a good deal, why are they selling it?
An old market saying is that IPO means "It's Probably Overpriced". Another market saying is that if you subscribe (ask your broker for some) and get all you ask for, it's going down; if you get a "partial fill", it's going up.
Although in a few cases - bringing Crown corporations public is one; demutualization is another - the pricing is such that the initial purchasers will be rewarded, in general it's better to avoid IPOs. The main purpose of many IPOs is to enrich the seller and the salesman at the expense of the buyer. New and fancy 'wrinkles', in particular, are usually marketing features that make the offering look pretty but that in the end will cost the investor money. Charles Ellis put it this way in his book "Winning the Loser's Game":
Don't invest in new or "interesting" investments. They are all too often designed to be sold to investors, not to be owned by investors. (When the novice fisherman expressed wonderment that fish would actually go for the gaudily decorated lures offered at the bait shop, the proprietor's laconic reply was, "We don't sell them lures to fish.")
As a good rule of thumb, the greater the twist, the more thorough the screwing.
Also, as this article discusses, secondary offerings [i.e. when a company issues additional stock to pay for a purchase] also underperform. Again, the reason is that stock is only issued when it is overvalued.
On the other hand, if a company announces a secondary offering then cancels it because of "poor market conditions", that means the merchant bankers think the stock will go up. Consider buying, if it looks otherwise attractive.