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IPOs: Land of opportunity or risky wager?

Initial public offerings can be enticing, but take care and do your research.

  • Fidelity Active Trader News
  • – 03/12/2015
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Some signs suggest that 2015 may be yet another good year for IPOs, with the online marketplace ETSY preparing for an offering, following strong debuts for cloud computing company Box Inc. (BOX) and burger joint Shake Shack (SHAK).

Indeed, during 2014, 273 companies went public, the most since the blockbuster IPO year of 2000 (when 406 companies went public).1 The amount of capital raised by these companies jumped 55% compared with 2013, to $85 billion (see the chart below).

2014 was punctuated by Chinese e-commerce giant Alibaba (BABA), whose $22 billion in proceeds from its September 2014 IPO was the largest ever.2

In addition to Box and Shake Shack, there are a number of highly-anticipated IPOs expected to possibly happen in 2015. But beware: IPO investing can be complex, and may be suitable only for experienced investors. If you are interested in investing in an IPO, here are some tips to consider.

Exercise extreme caution

One look at the performance of some of the best performing stocks on the day they went public would make it seem like there are opportunities to capture profits. Annual performance hasn't been to shabby, either. IPOs averaged a 21% return in 2014 (see the chart below).

However, that was actually down from a 41% average return in 2013. Additionally, many companies fail to generate any interest at all on their IPO date, and, unfortunately, investors can be left holding the bag.

Average returns for IPOs can vary widely.
2010 2011 2012 2013 2014
Avg. Total Return 25.1% -9.8% 20.5% 40.8% 21.0%
Avg. First-Day Return 9.6% 10.5% 14.1% 17.3% 13.5%
Avg. Aftermarket Return 14.5% -17.5% 5.6% 20.3% 7.2%
% Deals with Negative First-Day Return 31.8% 32.8% 18.8% 26.6% 27.3%
% Deals Priced Below the Range 41.6% 34.4% 39.8% 28.8% 40.0%
Source: Renaissance Capital. Includes IPOs with a market cap of at least $50 million and excludes closed-end funds and SPACs. Data through 12/31/14.

The stock of an IPO can be extremely volatile in its first few months, not to mention the heightened volatility that can occur on the first day of trading on an exchange. For instance, shares of online professional networking site LinkedIn (LNKD) more than doubled on its IPO date in May 2011, while Australian road building venture BrisConnections dropped 60% on its IPO date in July 2008.

Believe the hype?

Approaching IPO investing with caution may be a smart move because of the potential to get caught up in the exuberance that can surround a new, exciting company opening up its stock to the public. The reality is that for every AT&T (T), Google (GOOG), and Visa (V)—companies that had successful IPOs and are now entrenched leaders in their respective industries—there is a long history of initial public offerings that have not performed well.

Moreover, extracting value out of even successful IPOs can be tricky, from a retail investor’s perspective. For example, suppose you identify an attractive long-term IPO investing candidate that is priced at $20 per share on the IPO date. If you were to buy the shares at around this price, and by the end of the IPO period the stock price had doubled, you might think, “I’ve hit the jackpot!”

But take a step back. This means that the company and its underwriters (a financial group, typically a bank, that is responsible for determining the market price of an IPO) underestimated demand for the company’s stock. Therefore, the company lost out on the opportunity to raise more money to grow its business, because the IPO was mispriced (i.e., instead of receiving $40 a share from the public, it will have received only $20 a share).

In this scenario, if you were looking for short-term profits, great. If not, then a mispriced IPO may not be in the best interests of longer-term investors.

Do your homework

All too often, investors get caught up in IPO hype, rather than considering the opportunity within the constraints of their own unique goals and risk tolerance. The “everyone is doing it” mentality, which was palpably present during the IPOs of Facebook (FB) and other trendy tech companies, should not be why you consider investing in an IPO.

Like any other investment, before making any decision regarding an IPO, you should review your investment goals and conduct a thorough analysis of the company, along with its growth prospects. Each IPO is unique and needs to be evaluated independently to determine its investment potential.

The IPO market is unique and deserves careful analysis.
2010 2011 2012 2013 2014
Number of Deals 154 125 128 222 275
Proceeds Raised (US$) $38.7B $36.3B $42.7B $54.9B $85.3B
Median Deal Size (US$) $107.9mm $160.2mm $124.0mm $126.3mm $100.0mm
PE-Backed Deals 37 35 45 68 71
PE-Backed Proceeds (US$) $8.8B $20.4B $10.3B $24.5B $25.0B
VC-Backed Deals 61 51 46 82 126
VC-Backed Proceeds (US$) $6.0B $7.9B $20.7B $9.7B $35.3B
Average US IPO Return* 25.1% -9.8% 20.5% 40.8% 21.0%
Renaissance IPO Index 25.4% -16.6% 17.6% 54.3% 7.2%
S&P 500 12.8% 0.0% 13.4% 29.6% 11.4%
Russell 3000 14.8% -0.9% 14.0% 30.9% 10.4%
Source: Renaissance Capital. Includes IPOs with a market cap of at least $50 million and excludes closed-end funds and SPACs. Data through 12/31/14.
*Calculated as average return from offer price to 12/31 close.

Unfortunately, unlike stocks that are already public, there are distinctive risks to investing in IPOs, and perhaps even more things to be aware of if you are trying to make a tactical trade of an IPO.

One of the primary difficulties that retail investors face when it comes to researching companies that are not public yet is access to information. Publicly traded companies in the U.S., for example, are required by the Securities and Exchange Commission to disseminate financial information quarterly. Private companies are not required to do the same. Consequently, for the individual investor who does not have access to this information, it can be hard to fully assess the company’s merits as a sound investment.

A potential solution

One way that you might be able to navigate the intricate IPO waters is to consider investing with a fund or manager who has the resources to obtain the necessary research needed to do a thorough analysis.

This is not to say that it's impossible for individual investors to do the same. However, large investors like Fidelity have the research capabilities and resources needed to invest in the pre-IPO stage, which most individual investors are not able to do. Fidelity investors can sign up to participate in an upcoming IPO (login required).

Learn more

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Views and opinions expressed may not necessarily reflect those of Fidelity Investments. These comments should not be viewed as a recommendation for or against any particular security or trading strategy. Views and opinions are subject to change at any time based on market and other conditions.
1. Source: Renaissance Capital.
Past performance is no guarantee of future results.
There are risks associated with investing in a public offering, including unproven management, and established companies that may have substantial debt. As such, they may not be appropriate for every investor. Customers should read the offering prospectus carefully, and make their own determination of whether an investment in the offering is consistent with their investment objectives, financial situation, and risk tolerance.
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