IPOs draw heavy attention, but investors need caution

History indicates caution is the best bet for average investors when considering IPOs

Jun 8, 2014 @ 12:01 am

By Jeff Benjamin

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It is time to prepare for Alibaba-mania.

That would be the pending $15 billion initial public stock offering by Chinese-based online retailer Alibaba Group Holdings Ltd. The uproar seems appropriate considering the stock sale (tentatively set for Aug. 8, according to Bloomberg) was announced during the hottest IPO market in almost two decades and could surpass the $16 billion Facebook Inc. offering in 2012.

In other words, it would be difficult to overstate the size and significance of this offering.

Alibaba is a big, profitable, 15-year-old company that is 22% owned by Yahoo Inc. It has nearly 21,000 employees (fewer than eBay Inc.) and last year did more business than eBay and Amazon combined.

What does this all mean to investors? Not much, unless those investors are institutional or über-wealthy, or otherwise enjoy underwriter-level access to shares at the offering.

Fact is, IPOs tend to draw a lot of attention — and record-setting IPOs can draw record-setting attention — but rarely represent smart investments for regular people.

“Our clients are not interested in investing in IPOs, because this is not the way to build wealth,” said Jim Russell, senior equity strategist at U.S. Bank Wealth Management. Like a lot of market watchers, Mr. Russell views IPO activity more as an indicator of equity market enthusiasm than as an investment opportunity.

“More activity indicates higher business confidence, cash on balance sheets and companies' buying growth,” he said.

This year, 169 companies have filed to go public, compared with 256 for all of 2013. There have been 115 IPOs in 2014, versus 222 in 2013, and total proceeds have reached $23.5 billion against $54.9 billion for all of last year.

This year's 115 offerings have included

 -GrubHub Inc., 7.4 million shares at $26

 -Ally Financial Inc., 95 million shares at $25

 -Santander Consumer USA Holdings Inc., 75 million shares at $24

 -King Digital Entertainment PLC, 15.5 million shares at $22.50

 -IMS Health Holdings Inc., 65 million shares at $20

 -JD.com, 93.7 million shares at $19

“When the IPO market is very hot, it becomes dangerous, because the enthusiasm gets so elevated and little attention is paid to valuations,” said Linda Killian, portfolio manager at Renaissance Capital. “But that [level of unchecked enthusiasm] isn't the case now. On average, deals are being priced in a disciplined manner.”

Doug Coté, chief investment strategist at Voya Investment Management, calls IPOs “the plankton of the markets.”

“A lot of activity is a positive sign, because it means there's demand for equities and the animal spirits are present,” Mr. Coté said.

TOO SWEET TO PASS UP

Because the dollar amounts can be huge and performance numbers impressive, investors often tend to view IPOs as akin to a Black Friday sale that just can't be ignored.

But the reality is that results are most often mixed.

Consider the ballyhooed Facebook IPO, which debuted at $38 a share on July 25, 2012. Despite all the excitement from the social network's loyal consumer base, the stock price fell for the first six months of trading and took 14 months — until August 2013 — to return to the offering price.

Facebook now trades above $63 a share, and anyone who held on from the IPO is ahead 65%, but that initial nosedive was likely more than many casual investors could stomach.

Remember, the only reason to invest at the IPO is for the initial pop that somehow has been promoted as likely. After that first day of trading, it's just another public company that can be more easily bought or sold.

“In terms of performance, buying an IPO on the first day of trading doesn't translate to a lot of retail investor success,” said Rich Peterson, senior director at S&P Capital IQ.

There are always exceptions, but the broad averages don't make a convincing case for the average investor to jump into the IPO fray.

A 2013 study by University of Florida professor Jay Ritter analyzed the first five years' of stock performance of newly public companies and found that they tend to lag older public companies of comparable size. From 1970 through 2011, newly public stocks combined for a five-year average return of 10.6%, while companies with comparable market capitalization averaged 13.9%.

Even during the IPO heyday of the 1990s, newly public companies, which had an average return of 14.1% over five years, lagged comparable public companies, which averaged 17.1%.

“Unless you have the kind of access that lets you participate on the very first day, IPOs have horribly bad underperformance compared to stocks of similar size,” said Jared Kizer, director of investment strategy at BAM Alliance.

“Part of the explanation might be that most IPOs are smaller companies, and if you look at the classic Morningstar-style box, you find that the worst-performing asset class is small-cap growth on a risk-adjusted basis,” Mr. Kizer said.

Any case to invest in IPOs could be that the companies represent exposure to a category of stocks that aren't included in broad market indexes, at least at the beginning.

The First Trust U.S. IPO Index Fund (FPX) is one of the few funds that counts on investors' seeking diversified IPO market exposure. The semipassive fund holds the 100 largest IPOs and public spinoff companies for four years after they begin trading. The fund is up just 2.7% this year, compared with 4.8% for the S&P 500 Index. But it gained 47.8% last year, handily beating the S&P 500's 32.4% advance.

In fact, FPX has outperformed the S&P every year since 2008, when it fell 43.8% and the S&P lost 37%.

“In many ways, the IPO market is absolutely beholden to the public equity markets, because if you don't want to own what you already own, you certainly don't want to own something new,” said Greg Ingram, head of equity capital markets at R.W. Baird & Co. Inc.

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