Monday, November 29, 2021

What Investors Should Understand about IPOs  

An individual’s risk profile matters more than their age when shopping for these volatile investments.

Christopher Crawford
Christopher Crawford

IPOs (initial public offerings) are exciting news items that have garnered headlines in recent years. Under the right circumstances, they could potentially offer large investment returns. But they’re also highly speculative and many financial advisors shy away from them for cautious investors. That doesn’t mean they don’t have a place in retiree’s portfolios. Investors of any age who have high risk tolerance and are interested in getting in on the ground floor of an interesting new business should feel free to put in their buy orders if they understand the risks of buying IPOs. This includes anyone from millennials to baby boomer clients who are enjoying retirement. Here are some things that are important to know:

Evaluating IPOs

Since IPOs can be risky, brokerage firms set requirements for their investors to participate. The IPO could be limited to investors with a certain amount in their brokerage accounts or a minimum number of previous transactions in their name. Because companies issuing an IPO inform brokerages who then inform their investors, it is difficult to participate in an IPO without hiring a brokerage firm. The fact that brokerage firms are so careful about which of their investors can join in an IPO should make it clear that IPOs are not for everybody. Financial advisors should thus take a similar stance and explain the risks of IPO investments to their clients.

Overvaluation is the primary risk. Companies launching an IPO are incentivized to maximize excitement for the day their stock first becomes available. However, they must strike a balance between creating public interest in their brand without over-inflating that interest to the point that the stock immediately crashes. Unicorns and high-profile brands are especially vulnerable, as in the case of rideshare company Uber. Initially valued at $120 billion, its valuation dropped to $76 billion after one day of trading. Today, Uber is valued at around $86 billion, a significant differential from its launch.

Undervaluations often send up red flags too. An undervaluation can be perceived that insiders are not being totally upfront with the financials or another aspect of the company’s business. This can lead to inefficiency or volatile stock movements. Only an accurate valuation is positive for the buyer.

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When evaluating an IPO, investors should pay less attention to excitement and more attention to a company’s fundamentals, using both the company’s prospectus and information provided by a reputable third party whenever possible. Private companies are required to disclose all pertinent information before an IPO, but this data is still presented by the company in the best possible light, while a third party would be unbiased. Investors should also look at the company’s competitors, leadership, financing, and prior press releases, as well as the overall health of their industry. If hype and excitement are the noise about an IPO, then the state of the company and its field are the signal.

Stronger underwriters can indicate a stronger IPO. Quality brokerages, banks, funds, and venture capital firms have good track records picking investments that pay off. Underwriters are especially useful in this regard, as large and reputable companies like Goldman-Sachs can afford to be selective and make the sorts of well-reasoned, risk-averse choices individual investors should make. But even these institutions are not infallible and most have underwritten bad investments before, so their support is not a foolproof indicator of an IPO’s reliability.

Myth vs. Reality

Like meme stocks, IPOs can spawn a “gold rush” effect where the popular perception is that anyone can invest in an upcoming IPO and make a fortune overnight. In reality, only very large investors are likely to a good allocation of IPO shares. Companies can assign their stock to brokerages as they choose, and tend to favor larger, more reliable organizations. Thus, only connected investors with excellent brokerages are able to buy enough shares to significantly profit, even if the IPO holds its initial valuation or appreciates.

Ultimately, the numbers don’t lie: According to stockanalysis.com, as of September 30, 2021, there have been 771 IPOs on the US stock market in 2021, which is an all-time record. Of these, roughly 72% have lost value, and 17% have lost more than 15% of their initial value. Of course some IPOs have appreciated significantly, but the chance of an IPO investment paying off is small enough to make any wise investor cautious.

IPO Participation through Mutual Funds

The lead underwriters for IPOs generally allocate the vast majority of IPO shares to institutional investors, like pension funds and mutual funds. This leaves only a small percentage for retail investors. However, many mutual funds have bylaws that prevent them from investing in IPOs until the stock has traded for more than six months. In addition, many funds tend to be conservative in their investment approach, focusing only on investing in companies with attractive valuations, conservative debt, and free cash flow — qualities lacking in many of these IPO companies. The best option may be investing in mutual funds that offer exposure to early-stage companies — including some IPOs — rather than focusing exclusively on them.

Additional Reading: You Can Now Invest in Longevity ETFs, But Should You? 

Ultimately, investors interested in a company launching an IPO are better advised to wait and see how the stock evens out over time. Every IPO is an unknown value and unknown values are by nature volatile. Most serious investment portfolios only set aside a very small allotment for IPO speculation. One look at the IPOs from 2021 alone should give readers a good idea of how unpredictably these stocks can vary. Of course, daring investors can do very well with a timely IPO transaction. However, investors should consider IPOs a risky proposition, do as much research as possible, and limit their risk with smaller buys of less than 1% of their total investment portfolio.

 Christopher Crawford is head of Sales and Marketing at Buffalo Funds. With over 10 years of experience working with financial advisors and family offices, Christopher notes that success for advisors begins with being a good communicator and a better listener. Buffalo Funds is an asset manager with 10 actively-managed no-load mutual funds.

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