Investing in Initial Public Offerings (IPOs)

TL;DR

IPOs are often underpriced and getting an initial allocation is difficult, leading to poor expected outcomes for retail investors. IPO firms tend to underperform in the first two years.

Transcript

• An initial public offering, when a successful private company decides to offer shares to the public, is an exciting time for the company, its original shareholders, and the investing public. All of the excitement and publicity around an IPO often lead investors to want to get in on the action. If you can get in on the ground floor of an IPO, that... Read More

Key Insights

• 🤲 IPOs tend to be underpriced, creating an opportunity for quick profits, but getting an initial allocation is challenging for retail investors.
• 💪 Retail investors without significant assets or a strong relationship with their broker are unlikely to participate in the initial allocation.
• 💦 New mutual funds may leverage their institutional status to participate in IPO allocations, but their performance tends to drop after the first six months.
• ✋ IPO firms generally underperform in the first two years, behaving like high beta stocks with negative exposure to value factors.
• 🥺 Investing in IPOs on the secondary market usually leads to purchasing shares with a poor risk/return profile.
• 🏛️ Building a diversified portfolio of recent IPO stocks may provide better outcomes, but individual stock investments still carry company-specific risk.
• 🏛️ Investing in IPOs does not guarantee the returns of the asset class to which they belong.

Questions & Answers

Q: Why are IPOs underpriced?

IPO underpricing occurs because the underwriters set a price below where the market will likely price the shares. This creates a perception of an opportunity for investors to make a quick profit on the first day of trading.

Q: Why is it difficult for retail investors to get an initial allocation in IPOs?

The majority of the initial allocation typically goes to institutional investors, while retail investors, especially those without significant assets or revenue generation for brokerage firms, have a lower chance of participating.

Q: Do new mutual funds benefit from IPO allocations?

Yes, new mutual funds often use their institutional status and relationships to obtain IPO allocations as a strategy to boost their performance initially and attract new investors. However, their performance tends to decline after the first six months.

Q: Should investors buy shares on the secondary market if they miss out on the initial allocation?

Buying shares on the secondary market means investing in firms that tend to behave like small growth, low profitability, and high investment stocks. This type of investment often has an unattractive risk/return profile.

Summary & Key Takeaways

• IPOs are frequently underpriced, creating an opportunity for investors to make a quick profit on the first day of trading.

• Getting in on the initial allocation of an IPO is challenging, as the majority goes to institutional investors or larger brokerage clients.

• New mutual funds leverage their institutional status to participate in IPO allocations, potentially boosting their performance initially, but it tends to drop off quickly.