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Education - June 5, 2019

5 Things To Know Before Buying an IPO

IPOs? More like IP-woes, am I right?

Unless you got in on Beyond Meat (BYND) early — good for you if you did — you’re probably eating losses from that IPO you bought into this year.

While Beyond Meat, PagerDuty (PD), and Zoom Video Communications (ZM) have debuted with well-deserved hype, other big names like Lyft (LYFT) and Uber (UBER) have failed to live up to expectations. Several other “unicorns” (startups with a valuation over $1 billion) have also listed on public markets in the first half of 2019, and there are still a few more slated to go public before year’s end.

However, after private companies with massive valuations (and massive losses) received not-so-warm welcomes from public investors, cash-rich startups are actually punting on their original IPO plans. Palantir, the secretive data-analytics company co-founded by Peter Thiel, has reportedly pushed back its expected IPO date to 2020 due to reduced appetite on the public markets and other organizational reasons.

By nature, IPOs are big risk, big reward; investors have relatively little access to information and financial history with which to evaluate new listings. But how do you know which companies will thrive long term? Would you be better off investing your money elsewhere? What should you look for when evaluating a new IPO?

We analyzed 10 years of IPO history to answer the questions above and others. By evaluating major IPOs — the 25 largest from each year that are still trading — from 2009 to 2018, we can gain valuable insights for evaluating IPOs in 2019 and beyond.

If you’re looking to invest in an IPO in the near future, you should consider these five factors:

1. Only 38% of major IPOs have shown better returns than the broader market

“I swear, I almost bought Amazon at $4 back in ’97. If I had, I would be on my yacht right now.”

Sound familiar? Not even fishermen tell “big fish” stories as well as regretful investors do. But you’ve probably never heard someone say, “I was so close to buying an index fund back in ’98, but I missed my window. Too late now, I guess.”

Sure, it’s exciting to say you were an early investor in one of the biggest companies ever, but the data shows that about two-thirds of the time, you’d be better off just investing in the market.

We considered a hypothetical decision that investors would have faced: buy shares of a company on its IPO date or buy shares in an S&P 500 index fund, SPY, on that same date. We found that, since listing, only 38% of major IPOs have had higher Annualized Total Returns than the S&P 500. The chart below illustrates this point.

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2. Over the last 10 years, major IPOs have gotten progressively worse at keeping pace with market returns

From its listing date through Q1 2019, the average major IPO from 2009 has an Annualized Total Return 8.5 percentage points lower than the S&P 500. With the exception of 2015 and 2018, both years marked by relatively high volatility with large market drawdowns, that spread has widened, as shown by the chart below. In fact, the average major IPO that debuted in 2017 has underperformed SPY by 24 percentage points annually.

As previously stated, there is some major upside to be had if you’re able to pick a winning IPO, but that upside comes at the major risk of picking a loser. The fact of the matter is that, flashes of correction aside, we’re currently experiencing a record-length bull market, and it’s hard for new, individual stocks to keep up.

3. The spread between the most and least successful major IPOs in a year is widening

Above, we showed that you have a 38% chance of investing in an IPO that will yield an Annualized Total Return greater than that of the S&P 500. So what does it look like when you pick the best outperformer? What about the worst underperformer?

See the table below. What’s most interesting is the widening spread over time; the best IPOs are outperforming to a higher degree, and the opposite is true for the worst IPOs. If this trend continues in 2019 and beyond, the best- and worst-case scenario for any given IPO will become more dramatic, and investors’ risk tolerance will have to rise in kind.

4. Only Healthcare and Technology IPOs have outperformed, and by a relatively small margin

The chart below shows how major IPOs in different sectors have performed versus the S&P 500. The average Annualized Total Return for IPOs in Communication Services has lagged behind the market by 26 points, being dragged down by Cablevision successor Altice USA (ATUS); Energy IPOs have also underperformed by a significant margin.

Major IPOs in only two sectors, Technology and Healthcare, have both average and median Annualized Total Returns greater than that of SPY. While this doesn’t come as a total surprise because the Tech and Healthcare sectors have been market leaders in the new millennium, the slim margin by which they outperform, just 1.9 points and 4.0 points on average, respectively, is noteworthy.

If you want to invest in an IPO, it appears that a new listing in Tech or Healthcare is your best bet for outperformance. Fortunately, it seems like every new unicorn these days belongs to one of those two sectors.

5. More and more major IPOs are being filed by unprofitable companies

*Value investors, take a deep breath.*

Have you heard about Lyft’s $970 million annual loss? What about Uber’s $4 billion annual loss? Of course you have — who hasn’t? And these companies have admitted that they may never be profitable!

As of late, both private and public investors have grown more comfortable with companies that record massive losses in pursuit of market dominance. It’s definitely worked out before — cough, cough, Amazon — but value investors would balk at the valuations and market capitalizations given to companies that have never paid a dividend, let alone turned a profit.

Some recent IPOs with recognizable names that are still unprofitable: Tesla (TSLA) filed in 2010, Square Inc (SQ) in 2015, Workday (WDAY) in 2012, and FireEye (FEYE) in 2013.

The chart below shows how many of the twenty-five largest IPOs in each year reported a net loss in their filing year, and illustrates a slight upward trend before popping in 2018.

These 5 revelations may paint a dismal picture for IPOs moving forward, but that’s not entirely the case. Some recent IPO “winners” that have outpaced the market are Allergan PLC (AGN), Tencent Music Entertainment (TME), and Solarwinds (SWI).

The odds of getting rich off an IPO are surely stacked against you, but you could say something similar of any investment. It’s important to recognize that high risk tolerance is needed to play the IPO game; risk-averse investors should consider looking elsewhere for opportunities more suited to their risk profile.

On the other hand, you may employ a philosophy similar to that of venture capitalists: you’re okay with 80% of your investments returning losses so long as the other 20% pay out big.

Companies like SlackAirbnbPostmates, and The We Company are expected to list by the end of 2019. With these big names on the horizon, could our IP-woe turn into IP-whoa?

Data Information: In order to best reflect the opportunities available to the average investor, Annualized Total Returns were calculated using the closing price on a company’s first day of trading and returns through Q1 2019; data does not include any company that began trading in the period 2009–2018 but was subsequently taken private, wholly bought, or merged with another company; “major IPOs” refers to the largest 25 IPOs in each year by market capitalization as of a security’s first day of trading, or earliest date that both share price and shares outstanding were available.

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