Over the last two decades, the number of companies traded on American stock exchanges declined by roughly 40 percent, from nearly 8,800 in 1997 to less than 5,500 at the close of 2018, according to Terry Sandven, chief equity strategist for U.S. Bank. As a result, initial public offerings, or IPOs, are becoming “the lifeblood of stock exchanges,” Sandven says, as they fill in the gaps and replace companies that are bought out or merged.
When well-known or well-liked brands decide to become a publicly traded and owned entity, the media buildup around the IPO can often intrigue individual investors.
But IPOs tend to be a misguided topic for many investors. As a prospective shareholder, keeping an eye on the IPO calendar and buying stock when a company goes public might seem like an easy way to get in early. However, just because an IPO is garnering positive media attention doesn’t mean it’s the right investment.
Before investing in an IPO, it’s important to understand the misconceptions surrounding them and the opportunities they could present for investors.
1. Myth: If the public is excited about an IPO, I should invest
A well-liked or well-known company can still be a bad investment. You shouldn’t invest in an IPO just because the company is garnering positive attention. Extreme valuations may imply that the risk and reward of the investment is not favorable at the current price levels.
Investors should keep in mind a company issuing an IPO lacks a proven track record of operating publicly. Further, the competitive landscape of the market could affect an IPOs performance. These factors, and others, could negatively affect the success of an IPO and complicate an investor’s decision.
2. Myth: IPO investments will yield higher rewards than waiting to invest
Not always. Newly public companies are often categorized as high risk and volatile, as they lack a proven record of operating in the public domain. In Sandven’s opinion, financial results from investing in IPOs are mixed. “Not all IPOs are proven to be long-term winners,” he explains. “In fact, the company path toward financial greatness is littered with failed IPOs.”
Still, predicted growth often attracts the most attention to an IPO. Typically, investors are willing to pay higher valuations for the expected future growth, so IPOs tend to trade at higher multiples.
However, these high valuations could become troublesome during periods of economic slowing when investor angst rises and sentiment becomes more risk averse, Sandven warns. “You could argue that the U.S. economy is in the latter stages of the current 10-year running economic expansion cycle. Should a recession ensue, valuations and share prices would undoubtedly trend lower,” Sandven explains.
3. Myth: If a company is going public, it must be financially stable
It’s not that simple. An IPO has audited financials, but the future stability and predictability of these financials is uncertain. A company’s fortunes are often contingent on factors beyond its control. For example, many factors — such as the pace of global growth, tariffs, government regulation and stage in the economic cycle — could work against a company.
4. Myth: Only individual investors are awarded IPO shares
This is seldom the case. Institutional investors or fund managers tend to be the primary purchasers in an IPO – not individual investors. Institutional investors and fund managers typically have the means to purchase multiple shares at once.
Ideally, investment bankers — the people who provide underwriting services for companies that decide to go public — want to place IPO shares with investors who have longer horizons and are willing to hold shares rather than sell them in the open market, adding to share price volatility.
So, when a well-hyped company finally goes public, there may not be enough IPO shares for both institutional and individual investors to purchase. As a result, individual investors may have to wait for the secondary market, where securities are traded after the IPO.
5. Myth: Investing in an IPO gets me in on the ground floor
This is only partially true. Before going public, companies have likely gone through a few rounds of private investment. This means, IPO investors aren’t the first to have access. Rather, they are among the first public owners of a company.
It’s important to note: There will likely be a difference between the IPO offering price and the price an individual investor will pay for the stock on the market. The offering price, announced ahead of the IPO, is a fixed price reserved for institutional investors, employees and investors who meet certain eligibility requirements.
After careful consideration, if you’re still interested in a certain IPO, mark your calendar for the date when shares of the newly public company will be available to buy on the market. On this day, depending on share availability, purchases can be made through a brokerage account. An alternative for individual investors to purchase stock directly through an IPO is to consider investing in small-/mid-cap growth mutual funds, many of which are active purchasers of IPOs.
Sandven’s top piece of advice for potential IPO investors: Buyer beware.
“Know the company, the drivers of growth, the competitive landscape, valuations of similar companies and company-specific risks,” Sandven says. Not all initial public offerings are created equal. “Ideally, companies with competitive advantages in high growth markets with high barriers to entry trading at reasonable valuations afford IPO investors with a wonderful opportunity to participate in the early growth phase of the company’s life cycle. Unfortunately, the future for IPO companies is often less-clear, impacted by several unknowns including fundamental, macro and geopolitical issues beyond a company’s control.” This implies volatility and perhaps better suited for investors with longer term time horizons who can bear a substantial loss of principal.
As you continue to finetune your long-term investment strategy, consider whether alternative investments might help diversify your portfolio.