By LARRY SWEDROE
While they are often thought of as exciting (think Lyft and Uber), IPOs (initial public offerings) involve a great deal of uncertainty, which makes them risky. Thus, investors should expect higher returns as compensation for the higher risk. However, a large body of evidence demonstrates that unless you are sufficiently well connected (to a broker-dealer who is part of the issuing syndicate) to receive an allocation at the IPO price, IPOs have generally underperformed the overall market.
Professor Jay Ritter of the University of Florida has conducted a series of studies on IPO performance. His most recent study, updated in April 2019, covered the period beginning in 1980 and includes returns data through 2017.
Comparing IPO returns after the first day’s trading to similar listed stocks, Ritter found that, on an equal-weighted basis, they underperformed the market by a total of 17.9 percent over the three years following the IPO (not including the first-day return). The style-adjusted underperformance relative to other firms of the same size and book-to-market ratio was somewhat better, underperforming by an average of 7.1 percent.
Digging a bit deeper, Ritter found that larger IPOs faired better. Those with IPO proceeds in excess of $100 million (in 2019 dollars) slightly outperformed the market (+0.5 percent), and outperformed on a risk-adjusted basis by 4.3 percent. IPOs with proceeds of under $100 million underperformed the market by an average of 29.5 percent, and underperformed on a risk-adjusted basis by 14.2 percent. And the smaller the offering, the worse the results.
Using $1 billion as the breakpoint, Ritter found that the 635 IPOs that raised at least that amount outperformed the market by 7 percent, and outperformed on a risk-adjusted basis by 7.7 percent. Those raising under $1 billion did not fair as well. They underperformed the market by 19.9 percent, and underperformed on a risk-adjusted basis by 8.3 percent.
Does venture capital backing lead to outperformance?
Ritter examined the performance of VC-backed IPOs compared to the performance of those without VC backing. The 3,153 VC-backed IPOs underperformed the market by an average of 9.8 percent, but outperformed on a risk-adjusted basis by 0.4 percent. The 5,210 IPOs not backed by VCs underperformed the market by 22.8 percent, and underperformed on a risk-adjusted basis by 11.6 percent.
Ritter also examined the performance over sub-periods. The results for the period post-2000 were not very encouraging. There was no outperformance relative to the market, and on a risk-adjusted basis, IPOs on average underperformed by 6.6 percent.
Further evidence
Daniel Hoechle, Larissa Karthaus and Markus Schmid studied IPO performance in their March 2017 paper “The Long-Term Performance of IPOs, Revisited.” Their data set consisted of U.S. companies going public between January 1975 and December 2014. After applying several screens (such as depositories, real estate investment trusts, closed-end funds, partnerships and low-priced stocks), the final sample consisted of 7,487 IPOs. While prior studies looked at the returns of IPOs in the first few years, Hoechle, Karthaus and Schmid analysed IPO performance over varying time horizons, ranging from one to 40 quarters. Following is a summary of their findings:
- IPOs tend to be high-beta stocks and have negative exposure to the value factor.
- The Carhart four-factor (beta, size, value and momentum) model explains IPO underperformance over three- to five-year post-issue periods.
- IPO firms continue to underperform over the first two years after going public—even when differences in size, book-to-market and momentum are accounted for.
- Underperformance peaks at a risk-adjusted -2.4 percent per quarter exactly one year after going public—translating to underperformance in the first year in excess of 10 percent.
- Underperformance gradually declines, becoming insignificant beyond two years after going public.
- The findings were robust to different asset pricing models (specifically, the Fama-French three-factor model and their newer five-factor model, which includes profitability and investment).
- IPO underperformance substantially decreased after the Internet bubble burst in 2000. While IPO underperformance stayed economically meaningful at 1.5 percent per quarter and statistically significant at the 1 percent level, even for five-year post-IPO periods between 1975 and 2000, there was no evidence of significant IPO underperformance beyond one year after going public post-2000.
The authors reported other interesting findings:
1. Underperformance was concentrated in small-stock IPOs. Small-firm IPOs underperformed small mature firms over the first year after going public by a risk-adjusted 3.4 percentage points per quarter and was significantly different from zero at the 1 percent level. In contrast, there was no significant underperformance of large-firm IPOs compared to large mature companies, even in the first year after going public.
2. IPOs tend to be high-beta stocks. While not surprising, it’s important. The reason is that high-beta stocks have underperformed low-beta stocks, one of the most prominent anomalies in finance and a violation of the capital asset pricing model (CAPM).
3. A significant underperformance was associated with non-venture-backed IPOs for the first year after going public, but no significant difference was found in the performance of venture-backed IPO firms and mature companies. In fact, non-venture-backed IPO firms significantly underperformed mature companies up to five years after going public.
4. A large body of literature documents an underpricing of IPOs—a positive return from the offer price to the closing price of the first trading day. The authors found that IPO firms with both high and low underpricing significantly underperform mature firms over the first year after going public. However, they found IPO underperformance to persist for up to five years post-issue for low underpricing firms (the largest underperformance occurring in the first year), but for only the first-year post-issue for high underpricing firms.
5. The underperformance existed whether or not the IPO occurred in a period of “hot” issuance.
Hoechle, Karthaus and Schmid concluded that there’s a “statistically significant and economically meaningful underperformance of IPO firms over time horizons of up to two years even when the usual risk factors are accounted for.” They found this to be the case even after controlling for the new factor of investment—low-investment firms outperformed high-investment firms. Also of interest, they found that firms underperform when they are aggressive in terms of acquisitions.
Let’s take a look at one more study that updates data through 2018.
Dimensional’s research on IPO performance
Dimensional Fund Advisors studied the performance of 6,362 IPOs from 1991 through 2018. They created hypothetical portfolios of all IPOs with start dates in the prior 12 months, market cap weighted and rebalanced monthly. Returns were calculated based on the closing price at the end of the first day. IPOs returned 6.9 percent per annum, underperforming the Russell 3000 Index’s return of 9.1 percent per annum and the Russell 2000 Index’s return of 9.0 percent per annum. On a risk-adjusted basis the performance of IPOs was much worse, as their annual standard deviation of returns at 27.6 percent was almost double that of the Russell 3000, and 27 percent relatively higher than that of the Russell 2000. Over the more recent period 2001-18, IPOs returned 3.7 percent, underperforming the Russell 3000 and Russell 2000 returns of 6.0 percent and 7.3 percent, respectively, while again experiencing much higher volatility. Even over the glamour period 1992-2000, IPOs underperformed the Russell 3000 (13.6 percent versus 15.7 percent while experiencing almost triple the volatility), though they produced a 1 percent higher return than the Russell 2000 (but with double the volatility). (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
Little in the data demonstrates that investors were not well rewarded for taking on the incremental and idiosyncratic risk of IPOs. So what’s going on? There are two explanations in the literature: the lottery effect and the winner’s curse.
The lottery effect and the winner’s curse
It’s well documented that investors prefer “skewness” in returns—they’re willing to accept a high probability of a below-average return for the small chance of earning an outsized return (e.g., if they find the next Google). This is what’s often referred to as the “lottery effect.” The second explanation is referred to as the “winner’s curse.”
Eric Falkenstein explains the winner’s curse in his book “The Missing Risk Premium: Why Low Volatility Investing Works.” Let’s say you have to guess the number of jelly beans in a jar. If you compute the average of all the guesses of a large crowd, it’s usually very close to the actual number. While some of the individual guesses are off by a wide margin, the lowest guesses offset the highest guesses.
Now imagine this group in the context of an auction. The result of averaging the maximum prices everyone would pay for an item should be a very close approximation of the item’s true value. However, that’s not the way an auction works. The person who wins the auction is the one with the highest bid, which is obviously higher than the average price (or approximate value of the item), meaning the person will almost certainly overpay.
With a stock, some investors will perceive its value as higher than the market price and others as lower. That balance is what gives a stock its price. However, IPO stocks may not have that same balance for a few reasons:
- Not enough stock is available for pessimistic investors to short (and drive its price down).
- Institutional investors may have charters preventing them from shorting stocks.
- Shorting can be expensive.
- Investors may be too fearful of the unlimited loss potential associated with shorting.
As a result, the optimistic investors are the ones driving prices, causing the initial jumps associated with many new stocks. The “wisdom of crowds” applies to the average (mean) guesses of, say, the weight of an ox, or the number of jelly beans in a jar. It turns out that while there are large errors, they tend to be randomly distributed (both high and low). If the average guess is truly the best estimate, the highest estimates are biased upward.
The term “winner’s curse” was coined in the 1950s to describe the fact that, for auctions of oil fields, the winners were generally cursed by winning (if the average bid was closest to the best estimate of the correct value, the winning bid was too high). The same principle can apply to stocks, especially in cases where it’s difficult for arbitrageurs to drive the price back to its “true” value, as with IPOs.
The combination of the winner’s curse and the preference for skewness can explain not only the poor performance of IPOs but also the poor performance of small-cap growth stocks, penny stocks, stocks in bankruptcy, high-beta stocks and seasoned equity offerings.
IPOs with negative earnings
Severin Zorgiebel contributes to the literature on the performance of IPOs with his February 2016 study, “Valuation of IPOs with Negative Earnings.” Zorgiebel noted: “About half of all initial public offerings (IPOs) in the U.S. between 1994 and 2013 were initiated by companies with negative earnings. Especially during the dot-com phase, young high-tech companies initiated IPOs even when there was no product developed, no profits earned and oftentimes not even any sales. Interestingly, these firms found investors who were willing to invest in order to receive a portion of a promising idea that might turn into a multibillion-dollar business.” In other words, they were buying lottery tickets. But this isn’t just a dot-com craze. Very prominent IPOs Groupon, Twitter and Tesla are recent examples of IPO companies with negative earnings and very high valuations well after their dot-com phase ended.
Zorgiebel sought to answer the question: Are IPO companies with negative earnings valued higher compared to other IPOs? And if they are, then what are the drivers behind these potentially high valuation levels? Finally, he sought to test how these IPOs perform in the long term. He used a variety of valuation models provided in previous studies and implemented one from the field of mergers and acquisitions (used to evaluate how far the valuation of a target deviates from a “fair” value based on comparable companies in the market). Zorgiebel adjusted the models based on the previous findings in the literature (especially regarding growth). The model looks at such accounting metrics as book value, net income, leverage and growth expectations. Firm size is also accounted for. Zorgiebel then created matching peer groups of companies.
Zorgiebel’s data set included U.S.-based IPOs between 1994 and 2013. Penny stocks with offer prices below $5 as well as IPOs from the financial sector were excluded. Forecasts and growth expectations were based on IBES data. Press coverage was measured in terms of number of articles in the entire LexisNexis universe (with the IPO company mentioned in the article or headline beginning six months prior to its issue date). The final sample consisted of 2,655 IPOs with total proceeds of about $335 billion. Following is a summary of his findings:
- IPO companies with negative earnings are more likely to have VC backing, are younger, are more likely to be high tech companies and are smaller in terms of sales.
- IPO companies are valued higher compared to listed peer companies. The results hold for the periods before and after the dot-com phase, and are not only driven by high tech companies but are spread across a variety of industries.
- In general, there is a 38 percent valuation premium for IPOs compared to listed companies in the sample.
- High valuation levels are influenced by marketing campaigns undertaken by VCs and underwriters, and do not seem to be based on financial fundamentals.
- IPOs with negative earnings tend to be valued much higher compared to IPOs with positive earnings (66 percent versus 19 percent median valuation premiums), and they have greater levels of press coverage.
- IPOs with VC backing, a high underwriter ranking, that are small in size and have low leverage, high R&D expenses and high EPS growth rates offer higher valuation premiums. VC backing, underwriter ranking and EPS growth play an especially important role. Firms with VC backing and high-quality underwriters offer lower margins and greater levels of press coverage.
- Market participants adjust market prices over time after the IPO. As many of the loss-making IPO companies fail to monetise their high growth expectations over the long term, valuation premiums trend downward to the valuation levels of other IPO companies. As a result, IPO companies with negative earnings underperform the market and other IPO companies.
- In general, IPOs with negative earnings underperform in terms of share price performance after a period of 12, 24 and 36 months following the IPO. In the medium term of six months, no significant effect can be found (note the lockup period typically ends after six months). The underperformance of IPOs with negative earnings is even stronger compared to IPOs with positive earnings after 12, 24 and 36 months.
Interestingly, Zorgiebel found that IPOs with positive earnings are slightly undervalued compared to listed companies (-3 percent). This, along with his other findings, is consistent with those from prior research.
Another interesting finding was that the percentage of floated shares (out of the total number of shares outstanding) is highly negatively correlated with valuation premiums. This is logical because the smaller supply may act as a signalling device that previous shareholders have confidence in the future. It also reduces agency risks. And the smaller supply itself is a positive. Observe that a small float also increases the difficulty and cost of obtaining shares too short. Limits to arbitrage allow overpricing to persist.
Zorgiebel reached the following conclusion: “In a market environment of high uncertainty, heterogeneous beliefs, misperception of risk and return, and overconfidence, IPOs with negative returns might be different and more exposed to marketing hype than other IPOs. This effect is fuelled by the influence of VCs and underwriters.” He added: “Investors ‘learn’ over time and reflect reporting changes in the firm valuation. When initial IPO valuation is driven more by overconfidence than on market fundamentals, new information causes firm valuation to become closer to its intrinsic value due to lower information asymmetries. Investor overconfidence seems to play an integral role when IPO firms have negative earnings, which makes a fundamental valuation difficult to perform.”
The literature supports his view on the influence of investment banks and VCs, as it shows that there is a close relationship between the involvement of investment banks, marketing of IPOs and valuation. Investment banks have an incentive, due to their fee structure, to promote IPOs, induce sentiment investors and, consequently, to increase the valuation. Similarly, VCs, especially highly reputable VCs, have not only a certification role but also market power. However, these valuation levels are not sustainable and decrease over time.
Summarising, there is a large body of evidence on the relatively poor performance of IPOs. Zorgiebel contributed to the literature by showing the importance that IPOs with negative earnings have in the overall poor performance of IPOs. If you’re considering investing in IPOs and accepting their idiosyncratic risks, the evidence presented should serve as a strong warning that your investment may well be driven by overconfidence. The fact that IPOs have performed poorly has been long known in the literature. It’s why fund families such as Dimensional Fund Advisors avoid their purchase.
The bottom line is that when it comes to IPOs, despite their higher risk, unless you’re well-connected enough to get an allocation at the IPO price (the average IPO tends to jump on the first day), the returns have been commensurate with the incremental risks—risks that can be diversified away. As Richard Feynman, one of our most famous theoretical physicists said, “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with the experiment, it’s wrong.”
LARRY SWEDROE is Chief Research Officer at Buckingham Strategic Wealth and the author of 17 books on investing, including Think, Act, and Invest Like Warren Buffett.
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