Eye-popping IPO gains are the exception not the rule

The appetite of investors for initial public offerings has been on the up in 2014, with the hype machine set to go into overdrive when Chinese online giant Alibaba debuts in New York later this year.

Initial public offerings (IPOs) can be a source of feverish interest, but are they a source of real opportunity? Or is there truth to the joke that IPO stands for “it’s probably overpriced”?

Certainly, investor interest has been rekindled of late. In the US, the number of IPOs in the first quarter was the highest since 2000, with proceeds raised almost triple that of the same period in 2013. In the UK, 105 new companies joined the London Stock Exchange in 2013, the highest number since 2007, and activity has been even more brisk in 2014.

Currently, over-50s insurer Saga is preparing a £2 billion (about €2.45 billion) IPO, while online outfits such as Just Eat, AO World and Boohoo. com have all listed in recent months. In Europe, IPO proceeds are up 250 per cent on last year.

Nervy Recently, however, investors have grown nervy. In the US, Twitter has lost 60 per cent of its value since peaking last December; last month, eight IPOs priced below company expectations, the worst run since 2004.

In the UK, AO World has lost 40 per cent since its February IPO; Just Eat is 30 per cent below its IPO price; Card Factory shares suffered a double-digit decline following its recent London listing, while Pets at Home and Poundland are also below their offering prices.

While retail investors tend to get swept up in the hype surrounding high-profile IPOs, value investors often steer clear. Warren Buffett, for example, has not bought an IPO in more than 30 years, saying: "It's almost a mathematical impossibility to imagine that, out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller (company insiders) to a less-knowledgeable buyer (investors)."

Brokers point to examples like Microsoft – a modest investment in its 1986 IPO would be worth millions today – and Google, which has risen more than tenfold since its 2004 flotation. However, isolated examples don't reveal anything; to properly assess Buffett's caution, one must look examine the historical record.

Historical returns IPO expert Prof Jay Ritter has done just that, examining the returns of every US IPO since 1970. Typically, investors are left disappointed. Excluding first-day returns, IPOs have underperformed other firms of the same size by an average of 3.3 percentage points annually during their first five years. Marked underperformance was seen in each of the past four decades.

Many IPO investors have no intention of waiting five years, and Ritter’s stats show IPOs slightly outperform over the first six months. The picture gets ugly during the second six months, however, and underperformance becomes even more marked over the second year – on average, IPOs return just 5 per cent in their second year, compared to 13 per cent for their peers.

Valuation expert Prof Aswath Damodaran says this phenomenon is less pronounced for larger IPOs, although it still persists.

“Put succinctly, the primary payoff to investing in IPOs comes from holding the shares (not buying them) when the stock opens for trading on the opening day,” he says.

The IPO process “is a pricing game, not a valuation one”, says Damodaran.

It doesn’t matter what a stock is worth; what’s important is what investors are prepared to pay for it. Usually, that leads to steep valuations. A 2004 study looking at more than 2,000 IPOs between 1980 and 1997 found the median IPO was “significantly overvalued” – from 14 to 50 per cent, depending on the criteria used – relative to peers.

Overvalued IPOs have lower profitability and higher analyst growth forecasts than undervalued IPOs, the study found. The expected high growth fails to materialise, with profitability typically declining from pre-IPO levels.

Investors, it concludes, “are deceived by optimistic growth forecasts and pay insufficient attention to profitability in valuing IPOs”.

Storytelling Valuing IPOs is more difficult than valuing a listed company, with much less data to go on. In the absence of that data, it's easy to fall for the allure of stories, constructing a narrative that may be enticing but unrealistic.

It creates a lottery effect, with glamour stocks seen as the “next big thing”, and valuations oscillating manically.

Twitter, for example, looked exorbitant at its $26 (about €17) IPO price, but intense demand saw it open for trading last November at $45. A month later, it touched $75, valuing the company – which had not yet turned a profit – at $40 billion.

By focusing on the story, analysts got to defend Twitter's seemingly absurd share price. "It is far too early to be focused solely on valuation," said Jordan Rohan of Stifel Nicolaus, in January. Twitter is "revolutionary and disruptive", with "significant scarcity value".

Many of the same valuation-based arguments were valid at lower price levels, he said, but that didn’t stop prices rising. “As Twitter shares extended to new highs, we believe that these arguments became less defendable.” Indeed.

Reality bit in recent months, however, the stock now hovering around $30. Look for profits Not all IPO data is unfavourable. Ritter has found profitable technology companies that went public between 1990 and 2011 rose 55 per cent over the following three years, compared to a 22 per cent rise for money-losing companies.

Opportunities are scare nowadays, however – in 2013, just 28 per cent of US technology IPOs were profitable firms. This year’s figure, 23 per cent, is even lower.

Ritter also found that companies floating during periods of few IPOs tend to be stronger – they have to be, to secure the little money that is available at such times. In 2008 and 2009, for example, more than two-thirds of US technology firms going public were profitable, compared to just 29 per cent in 2007, when money was sloshing about.

In 1990, 94 per cent of tech IPOs were making money, but that figure plummeted as the decade progressed, hitting lows of 14 per cent in 1999 and 2000. Ritter has found that since 1980, companies that went public in periods of few IPOs performed 8 per cent better than the overall market over the following three years. In high-volume periods, they performed 21 per cent worse than the market.

Recent results Despite eye-popping gains briefly enjoyed by a handful of recent IPOs, these offerings have stuck to the historical script over the past 12 months. The average US IPO has gained an estimated 12 per cent from its offering price.

However, few investors buy at that price, as the stocks usually open for trading at a much higher level. That’s why investors who bought at the closing price on the first day of trading are nursing losses of 3 per cent – a dreadful result, given the overwhelmingly bullish environment.

Similarly, the action seen in recent IPOs in the UK will have sobered up skittish investors. It can be tempting to get on board the IPO bandwagon, but the data suggests Buffett is right – it’s generally better to wait.