The flow of new companies prepared to trade their shares on the stock market and raise money from investors – known as an Initial Public Offering, or IPO – is widely viewed as a bellwether of market confidence. With every new company, investors have to weigh the upside opportunity against the risk of the unknown. They also have to take account of the intriguing patterns in the way shares in newly-listed companies typically perform, which is essential knowledge in any investor toolkit.
In May 2011, social network LinkedIn began trading in the US at $45 per share and closed the same day at more than twice the price. For the financial institutions that backed the company on its introduction, that performance cemented a widely-held view that IPOs have a tendency to be under-priced and, as such, you’d be mad to miss them (known as "the IPO effect").
As readers will know, we're rather keen on opportunities to exploit market inefficiencies, so what do we make of this one? Well, the trouble is that, as usual, there's more to it than the received wisdom would suggest. The headline-grabbing London IPOs of commodity trader Glencore and Russian gold producer Polymetal in 2011 produced muted first-day performances. Meanwhile, shares in food retailer Ocado immediately fell 12% on their introduction and took another five months to recover. At the smaller end of the market, the Alternative Investment Market IPOs of 3Legs Resources and Nandan Cleantec both achieved initial surges – but like their larger-listed IPO peers, the shares in those companies went on to produce very different performances in the months that followed.
How IPOs Work
Before exploring these trends further, it’s worth looking at how private investors can go about getting in on an IPO – because the answer to that has much to do with the way in which these deals are priced.
The rough guide to IPOs begins in the gleaming fortresses of City investment banks, which are hired by companies to handle the sale of their shares (presumably for as much as possible or whatever potential buyers can stomach). During these discussions the two sides will iron out whether the bank will buy the entire issue and then sell it on (underwrite) or whether they will simply get their broking team to shift as many shares as possible (best efforts). Friendly institutions will be sounded out about what they think of the company and what they would be prepared to pay. Before those initial flirtations are turned into irrevocable undertakings to buy shares anyone can pull out, so the bank will probably be a) chatting up its best clients and b) attempting to secure commitments for many more shares than it actually has to sell (the Glencore offering was four times oversubscribed).
4 Factors That Investors Need to Know About IPOs
With the mechanics of the IPO process in mind, what should individual investors be aware of when it comes to investing in newly-listed companies?
1. Buying shares in an IPO is very difficult
A quick glance at the make-up of an IPO clearly shows that private investors aren’t really part of the equation. Unless you have a client account at the underwriting bank in question, are an active, cash-rich and reliable share buyer or you have an ETF that buys IPOs, then the options are limited. Obviously, investors have access to the open market (and many institutions that buy pre-IPO also commit to buying further shares after the introduction) but by then the excitement could be all over. In some instances you may be able to buy shares pre-IPO but, again, this will rely on the strength of the relationship between you and your broker (and the access your broker has to these situations).
2. IPOs are typically under-priced
Regardless of the limited evidence of a few London IPOs 2011, academics are generally in agreement that there has been a long-term trend of IPOs being under-priced. Research into this phenomenon is extensive, not least because it sits awkwardly with another academic notion, the Efficient Market Hypothesis, which claims that the market is a ruthless mechanism and that the current price of a stock is always the most accurate estimate of its value. Academics blame a number of factors for under-pricing, including behavioural finance and asymmetric information between companies, bankers and investors.
The earliest (and most obvious) supposition was that underwriters under-price new stocks to make it easier for them to sell to institutions – after all, if they failed to get the IPO away they would lose money. Indeed, in some cases, a failure could lead not just to a haircut but a lawsuit. In 1982, Baron argued that companies simply accepted that their bankers knew more about the markets (and buyer demand) than they did and were prepared to pay for that knowledge through the under-pricing of their shares.
Research in 2004 by US academics Loughran and Ritter, found that the average first-day return on US IPOs during the 1980s was 7%. That figure doubled to almost 15% during 1990-1998, before jumping to 65% during the internet boom years of 1999-2000 and then reverting to 12% during 2001-2003. According to Coakley, Hadass and Wood, the US example corresponded to a pattern of under-pricing in the UK during the same period.
Indeed, the extreme under-pricing that was witnessed during dotcom bubble led commentators to draw other conclusions, including the existence of conflicts of interest. Loughran and Ritter argued that, in that period, “analyst coverage and side payments to CEOs and venture capitalists became of significant importance”. That was a kind way of putting it – other commentators suggested that some banks (some of which have since settled multi-million dollar claims) were under-pricing IPOs in return for kickbacks through commissions and other lucrative deals. Meanwhile, institutional buyers of these IPOs made a mint ‘flipping’ or selling the stock the same day at a significant profit.
3. IPOs pitch private investors against institutions
For those investors who suspect that somewhere along the line someone is loading the IPO deck, a 1985 research paper by then Harvard professor Kevin Rock presents another possible under-pricing model. Based on what is known as the Winner’s Curse, the argument assumes the existence of a group of investors whose information is better than that of the company and all other investors. If the new shares are priced at their expected value, these privileged investors scoop up the shares when good companies are offered and back off when bad companies are offered. As a result, Rock said the underwriter would have to price the shares at a discount in order to guarantee that the uninformed investors purchase the stock.
This theory was taken a stage further in a 2008 paper by Adams, Thornton and Hall, who proposed a behavioural model that suggested that large IPOs tend to be less under-priced than smaller offerings – the smaller the IPO, the more it is under-priced. They argued that initial returns were also much greater during bull markets than in calm conditions – which squares with the idea that investors in financial markets are prone to irrational exuberance. Finally, they also concluded that companies think very carefully when it comes to choosing their IPO share price and that “economically significant differences exist across firms choosing different IPO prices in the amounts of ‘money left on the table’.” In other words, there is a theory that the IPO share price is a marketing tool designed to appeal to certain investors depending on the circumstances and the size and/or quality of the company.
4. IPOs underperform in the short and long term
According to some findings, anyone buying shares in the aftermath of an IPO has the odds stacked against them. A 1995 paper by Loughran and Ritter found that IPOs typically produced returns of just 5% over five years for investors – and that this was mainly down to a ‘valuation problem’ caused by a lack of financial information about the company in question. Other commentators, such as Brav and Gompers, have claimed that the phenomenon is not straightforward and that other variables, such as book-to-market value, are at play.
A 2009 paper by Hoechle and Schmid sampled 7,378 firms going public between 1975 and 2005 and found that typically those firms underperformed during the first year for numerous reasons. Interestingly, they also found that IPOs associated with overly optimistic growth prospects (and correspondingly high valuations) and companies floating during ‘hot issue’ periods performed substantially worse than other IPOs.
In 2011 there were 76 IPOs on the London Stock Exchange’s primary and secondary markets, raising an aggregate of £12.9 billion. For private investors, these flotations offer complex opportunities and potential pitfalls. If you can buy the shares early on (and that is a big ‘if’), the empirical evidence suggests you will have bought them cheap and the stock should enjoy a short-term spike. However, longer term, these shares have been shown to underperform. Indeed, the limited financial information and track record that are inherent with new introductions presents a situation that is at odds to the traditional advice of carrying out detailed research before buying shares and the guidance of investors such as Peter Lynch, who urged “buy what you know”.
- Wikipedia on IPOs
- IPO Pricing Phenomena: Empirical Evidence Of Behavioral Biases, Adams, Thornton, Hall
- Market efficiency, long-term returns, and behavioural finance, Fama
- The New Issues Puzzle, Loughran and Ritter
- IPO Home, Renaissance Capital