Initial public offerings (IPOs) are supposed to represent the
Holy Grail. It's your chance to own the next Microsoft or the next
Google. But is it really your lottery ticket to riches?
Here's what usually happens: People buy stocks at the wrong price
hoping for a quick gain and more frequently end up with quick
losses.
Social media stocks are 2012's poster child for what can go
wrong. Overhyped IPOs like Facebook (NasdaqGS:FB), Zynga
(NasdaqGS:ZNGA), and Groupon (NasdaqGS:GRPN) were promoted as a
sure thing. Since its May debut, Facebook has already lost more
than half its value and Zynga around $2.50 per share is now a penny
stock. (Unlike Wall Street's spin doctors, the
ETF
Profit Strategy Newsletter
warned its readers to avoid Facebook before it went IPO.) As a
group, social media stocks (NYSEARCA:SOCL) have only gained 2.41%,
which lags the broader stock market (NYSEARCA:VTI) by very wide 12%
margin.
Does that mean IPOs are a bad investment? Not necessarily.
Since 1980, the average first day return for IPOs has been 18%.
But here's the problem: Those returns are based upon buying the IPO
at the stock's offer price and selling it on the first closing day.
Most investors can't buy IPOs at the offer price, because only the
underwriters' favorite clients are given that chance. Instead,
investors have to buy the IPO in the public market, usually after
its price has already "popped."
Does buying and holding an IPO improve your odds of making a
profit? Not necessarily.
The chart below shows that more than 50% of the IPOs over the
past three years lost money during the first three and six months
of trading. Here's another fact: The odds of losing a large amount
of money (more than 10%) jumped in moving from 3 to 6-month holding
periods. This could be due to the lock up period, which is
generally between 90 and 180 days when company insiders are
restricted from selling their shares. After the lock-up period
expires, downward pressure on the stock can follow. (VIDEO:
Facebook IPO Burns Investors
.)
For longer-term investors, here's more sobering numbers: The
3-year buy-and-hold returns for IPO stocks lagged the average
3-year cumulative returns of similar non-IPO stocks by 7.4% from
1980 through 2011, according to data from Professor Jay
Ritter of the University of Florida. His research also showed that,
from 1970 to 2010, IPOs have underperformed similar non-IPO stocks
by an average of 1.8% per year during the first five years after
issuance.
Interestingly, there have been some disconnects with the
intermediate performance (5-years) of IPOs easily beating the
broader stock market.
Over the past five years, the First Trust U.S. IPO Index ETF
(NYSEARCA:FPX) has gained 14.60% compared to a 6.52% loss for the
S&P 500 (NYSEARCA:SPY). FPX's index includes the 100 largest
and most liquid U.S. IPOs. Holdings are given a 10% cap and
holdings are rebalanced quarterly. FPX's annual expense ratio is
0.60%.
This year's lackluster performance of social media IPOs isn't
good and neither are the shelved plans for upcoming IPOs like Dave
& Buster's, Fender Musical Instruments, and MobiTV. With major
stock indexes near their all-time highs, it's quite suspicious that
IPOs are being delayed. "Unfavorable market conditions" are the
typical excuse given for halting an IPO.
In summary, unless you're a corporate insider or an underwriter,
IPO investing isn't a get-rich quick strategy. For every LinkedIn (
LNKD
) or Google, there's an ocean of losers.
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