The XYZ initial public offering (IPO) is coming.
Yeah. You know Company XYZ. The tech company!
The one that’s unprofitable but every money manager is clamoring to own.
You know… the one stock that every YouTuber, TikToker
Well… you shouldn’t.
Because I want to tell you the truth about IPOs…
Some people might make a fortune off the first day of trading during the next hot IPO.
Those people likely won’t include you.
I want to explain something really simple about how the IPO process really works.
So, unless you take the time to really learn how to invest in IPOs, I would exercise some caution the next time someone pitches you the next company going public.
When a company decides to do an IPO, they hire an investment banker.
The banker puts the deal together and begins the selling process.
They hit the road. The roadshow goes to all the big financial center cities like New York, Chicago, San Francisco, and Boston.
The underwriting firm feeds the analysts and fund managers booze and snacks and tells their story.
The firm calls on all big hedge funds and institutional investors that skipped the roadshow to sing the song.
The underwriting firm is running the order book. If the deal is oversubscribed and is likely to pop big the first day, only their biggest and best clients will get allocations.
Maybe some relatives of the top execs will get a few crumbs.
You can join the rest of the people who are willing to buy the bag from the private investors on Day One.
Sometimes, you’ll get a good trade on that first day that the stock goes public.
But most times, it’s going to be a loser’s game.
You may get the warm and fuzzies for an hour or two,
It won’t be too long before the warm and fuzzies turn into the cold and crappies.
If you ask your broker for shares in what’s rumored to be a hot deal, and you get all the shares you requested, you are screwed. The deal has failed, and the price you are paying is likely to be the highest price the stock ever sees.
If you try to sell the first day, your broker will see to it you never get another share of an IPO again.
IPOs are a loser’s game for most people who don’t prepare the right way..
If it’s a good deal, you can’t buy it.
If you can buy it, it’s a horrible deal.
If you try to buy after that initial one-day pop, your long-term returns are probably going to be awful.
Lessons from Mr. IPO
Let me offer a few lessons on how to do this the right way.
I’ll take my cues from Professor Jay Ritter of the University of Florida.
People call him Mr. IPO.
Ritter’s done extensive research on initial public offerings.
As exciting as the firms and the press make IPO investing sound, it has not really been profitable if you don’t get shares in the initial offering.
From 1980 through the end of 2018, the good professor found that IPOs have underperformed the stock market by a pretty wide margin.
You would have been better off just sticking your money in an index fund and avoiding all the hype, hysteria, and heartbreak.
Keep in mind all the research is based on buying all the IPOs that come to market.
I can’t even do that, and I’ve been making money in the markets for decades.
There are too many of them every year.
Thanks to the self-centered allocation practices underwriters use to divvy up IPO shares, I couldn’t even buy all of them if I wanted to try.
We add a huge element of luck by playing a guessing game to pick which new company we want to try and chase in the post-IPO market.
As my colleague Ben Sturgill pointed out on Thursday, IPO companies that are profitable like GoodRX (GDRX) that have actual profits are extremely rare this year.
Most of the deals we are seeing come to market are tech companies that are still losing enormous amounts of money.
Odds that a secondary offering to raise additional capital before too long are pretty high.
That offering usually limits demand for existing shares, so the stock price often drops when a secondary deal is announced.
Do This Instead
As long-term investors, we’re best served by almost ignoring the IPO market or by waiting for a pullback to happen that aligns with strong financial numbers and a stronger outlook.
If it truly is a world-changing company, we will get our chance to buy the stock on better terms most of the time.
When the share lockups that restrict insiders from selling expire, we will start to see the founders and venture capital firms locking in some profits, and that could push the stock down to a more attractive entry point.
IPOs are easy to hype.
The stories can be sexy as hell.
The promise of unimaginable profits from a fantastic story is alluring.
Ignore the hype.
If the potential is real, you will not get shares in the offering.
Buying the first-day pop has proven to be unprofitable most of the time.
If the potential proves to be elusive, then you could end with a real dog stock that destroys a lot of your cash.
Eventually, there will be a bear market, and almost everything will be on sale.
Then we can buy the proven world-beaters at bargain prices that help us build generational wealth.