What the Past May Tell Us About IPOs

July 31, 2012

John Wightkin
Director of Equity Research Applications, Schwab Center for Financial Research

Several high-profile initial public offerings (IPOs) have taken place during the past year, many related to social networking. The lure of the possibility of large, quick profits, and memories of successful IPOs like Google, had many investors fighting for a piece of these offerings.

Before jumping into the next IPO, you may want to step back and do a little research into how IPOs have performed in the past. This historical perspective could help you decide whether you’re ready to play the IPO game. Let's take a look.

Whenever an IPO is announced, many investors get into a fluster. After all, they're bound to profit when the price jumps the first day, right? Not necessarily. Based on research from Professor Jay Ritter of the University of Florida¹, one of the country's leading authorities on IPOs, the average first-day return for IPOs since 1980 has been 18%. With potential returns like this, it's no wonder many investors clamor for stocks that have just gone public.

However, most investors can't get these returns. Why? Because they're based on buying at an IPO's offer price, which retail investors rarely get a chance to do, and selling at the closing price of the first day of trading. Typically, only the IPO underwriters' best clients are afforded this opportunity. Instead, most investors have to buy the IPO once it starts trading in the public market.

To better understand how buying in the public market might affect the first-day performance, I examined the one-day return patterns of IPOs that went public over the last three years. There were 465 IPOs in our sample. I calculated the first-day return to these IPOs using both the offer price and the opening price as the purchase price and the closing price as the selling price. I then grouped the stocks into four buckets (less than -10%, (-10%) to 0%, 0% to 10% and greater than 10%) based on their one-day return and calculated the percent of stocks comprising each group. The graph below shows the results of this research.

First Day of Trading

Source: FactSet, Schwab Center for Financial Research, data from May 14, 2009 through May 10, 2012. Assumes no transaction fees or expenses.

One important insight that can be drawn from this comparison is that investors who were fortunate enough to buy at the offer price had a better chance (29% versus 9%) of realizing a large positive return (greater than 10%). Less significant, but still noteworthy, was that approximately 55% of the IPOs over the past three years lost money the first day when buying at the opening price, while only 43% lost money when buying at the offer price. Keep in mind that these returns are not representative of actual client experience, since investors may have sold shares intraday or held them overnight.

Another common belief is that "flipping" IPO shares—selling a few days after the company goes public—is a successful strategy. Using the same IPO sample set, I found that the average four-day return (from the close of the first day to the close of the fifth day) was -0.2%. I also discovered that an investor had an equal chance (42%) of gaining up to 10% or losing up to 10% in the four days after the IPO date. Earning quick profits from an IPO isn't necessarily as certain or lucrative as some investors may think.

Schwab defines "flipping" as buying shares of an IPO and selling them within 30 days of the date the IPO goes public. Schwab clients who flip shares from a public offering will be restricted from participating in initial and secondary public offerings through Schwab for 90 days.

Holding IPOs for a few months after the IPO date doesn't necessarily translate into larger profits either. 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. Equally interesting is the fact that the odds of losing a large amount of money (more than 10%) increased in moving from three- to six-month holding periods. Perhaps this is due to the lock-up period—the period of time, usually between 90 and 180 days, during which insiders are prohibited from selling their shares to the public. Insider selling after the lock-up period could put downward pressure on the stock.

Holding IPO Shares No Guarantee, Either

Source: FactSet, Schwab Center for Financial Research, data from May 14, 2009 through May 10, 2012. Returns calculated from the close of the first trading day. Assumes no transaction fees or expenses.

Focusing on the longer-term performance of IPOs paints a similar less-than-stellar performance picture. Professor Ritter's research cited above found that the three-year buy-and-hold return of IPO stocks, from 1980 through 2011, lagged the average three-year cumulative returns of similar non-IPO stocks by 7.4%. 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 issuance².

The evidence suggests that investing in IPOs isn't always the quick, get-rich strategy you might expect—or, on average, a particularly attractive long-run strategy. From a historical perspective, getting in at the offer price appears to be the only source of excess returns for IPOs. So why might IPOs provide this less-than-stellar performance?

One reason could be all the hype and marketing around an IPOs, as market expectations for an IPO could be too optimistic. When such lofty expectations aren't met, the stock, on average, may disappoint investors. The research cited above seems to support this premise.

Knowing more about the potential payoffs and risks to IPOs, are you still interested in investing in them? Here are a few guidelines to consider:

1. Do your homework. It's hard enough to analyze the stock of an established company—an IPO can be even trickier since there won't be a lot of historical information. So try to research the company behind the IPO just as you would any other stock—a tough task given the limited research data and sources. (Unfortunately, Schwab Equity Ratings won't rate IPOs until they have a sufficiently long history of prices—about two months—and reliable, publicly available financial statements. So, in addition to facing the risks inherent in investing in these stocks, IPO investors can't utilize the guidance of our ratings.)
2. Read the "red herring." This document is the prospectus that contains the most important information about the company.
3. Be careful about buying a stock on the first day—especially at the opening price. As our research demonstrated, historically there's more than a 50% chance of losing money the first day, and the odds of making money don't improve substantially in the long term.
4. Understand that the stock price could come under some selling pressure three to six months after the IPO date as the lock-up period expires, allowing insiders to sell their shares to the public.
5. Be sensitive to the fact that IPOs are sold to raise money for the company as well as for existing shareholders. The company and underwriters are incented to build excitement around the offering to get the best price possible. We believe that the research presented above and published elsewhere seems to indicate that these marketing efforts cause an IPO to become overpriced, on average.
6. Consider IPO investing in relation to your risk appetite and longer-term investment strategy.

1. Jay Ritter, "Initial Public Offerings: Tables Updated Through 2011," May 2012, available at bear.warrington.ufl.edu/ritter/IPOs2011Statistics70512.pdf

2. Jay Ritter, "Returns on IPOs during the five years after issuing, for IPOs from 1970-2010," April 2012, available at bear.warrington.ufl.edu/ritter/IPOs2011-5years_052012.pdf