The Dismal Track Record of IPOs
While many investors think that initial public offerings (IPOs) are exciting, they are risky investments. Academic research shows overwhelmingly that the returns to investors are not commensurate with the risk.
Classical economic theory suggests that because they are riskier, IPO investors should expect higher returns as compensation. 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, and by wide margins. Confirming evidence on this phenomenon has been detected in the U.S., the U.K., Australia, Germany and France.
The most recent evidence is from Smadar Siev and Mahmoud Qadan, authors of the September 2022 study, “Call Me When You Grow Up: Firms’ Age, Size, and IPO Performance Across Sectors,” in which they examined the near- and longer-term performance of 1,611 U.S. IPOs spanning 11 sectors over the period 2009-2019. Abnormal returns were calculated against three different benchmarks: the S&P 500, the Russell 2000 and sector indices. Following is a summary of their findings:
- Two sectors out of 11 – healthcare and technology – were responsible for 47% of the firms going public.
- There was a significant variation in the long-term performance between sectors and between small and large firms within each sector.
- Smaller IPOs underperformed more than larger IPOs – smaller IPO firms produced a cumulative average abnormal return (CAAR) versus the S&P 500 Index of -42.77% one year post IPO, - 89.26% two years after the IPO and -113.91% three years after the IPO, while larger IPO firms had a CAAR of -14.59% for one year post IPO, -27.74% two years post IPO and -25.57% three years after the IPO. Results were similar against the other two benchmarks and within sectors. For example, in the healthcare sector, small firms had a CAAR of -23.22%, -32.57 and -63.49% versus the CAAR of large firms of -16.37%, -22.12% and -16.54% for 200, 300 and 550 days post IPO, respectively.
- There was a clear tendency of firms from sectors such as healthcare and technology to go public at a relatively younger age than other sectors. For example, on average, healthcare (technology) companies went public at 10 (13) years, while those in basic materials (industrials) did so at 30 (34) years – firms in healthcare and technology issue IPOs earlier in their life cycle due to their need for financial resources to develop a drug or technology.
- A firm’s age increased gradually across quintiles. For example, while the average firm age in Q1 was 10.3 years, it rose to 28.2 years in Q5 – older firms have more time to establish and expand their business.
- Older IPO firms performed better than younger ones regardless of the time window. Breaking IPO firms into three groups, Portfolio A1 consisted of very young firms between 1 and 6 years old; Portfolio A2 consisted of slightly more mature firms between 7 and 13 years old; and Portfolio A3 consisted of the most mature firms that were 14+ years old. Portfolio A1’s CAAR was -7.44%, -20.5%, -30.81% and -45.99% compared to Portfolio A3’s CAAR of -3.82, -10.39%, -17.58% and -28.81% for 100, 200, 300 and 550 days post IPO, respectively.
Siev and Qadan’s findings are similar to those of Daniel Hoechle, Larissa Karthaus and Markus Schmid, who studied IPO performance in their 2021 paper, “The Long-Term Performance of IPOs Revisited.” Their data set consisted of almost 7,500 U.S. IPOs between January 1975 and December 2014. Hoechle, Karthaus and Schmid analyzed IPO performance over varying time horizons ranging from one to 40 quarters. Following is a summary of their findings:
- IPOs tended to be high-beta stocks and had negative exposure to the value factor.
- The Carhart four-factor (beta, size, value and momentum) model explained IPO underperformance over three- to five-year post-issue periods.
- IPO firms continued to underperform over the first two years after going public – even when differences in size, book-to-market and momentum were accounted for.
- Underperformance peaked at a risk-adjusted -2.4% per quarter exactly one year after going public – translating to underperformance in the first year in excess of 10%.
- Underperformance gradually declined, 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).
- Underperformance was concentrated in small-stock IPOs.
- 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.
- While 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 – IPO firms with both high and low underpricing significantly underperformed mature firms over the first year after going public. However, IPO underperformance persisted 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.
- The underperformance existed whether or not the IPO occurred in a period of “hot” issuance.
Hoechle, Karthaus and Schmid concluded that there is 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 underperformed when they were aggressive in terms of acquisitions.
What explains the anomaly of such risky investments underperforming?
The lottery effect
It’s well documented that investors prefer positive 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.”
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 contributed to the literature on the performance of IPOs with his 2016 study, “Valuation of IPOs with Negative Earnings,” in which he noted that about half of all IPOs in the U.S. between 1994 and 2013 were initiated by companies with negative earnings. Interestingly, these firms found investors who were willing to invest in 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 those IPOs performed 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). His model looked at such accounting metrics as book value, net income, leverage and growth expectations. Firm size was 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 and IPOs from the financial sector were excluded. Forecasts and growth expectations were based on IBES (Institutional Brokers Estimate Service) 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 were more likely to have VC (venture capital) backing, were younger, were more likely to be high-tech companies and were smaller in terms of sales.
- IPO companies were valued higher compared to listed peer companies. The results held for the periods before and after the dot-com phase, and were not only driven by high-tech companies but were spread across a variety of industries.
- In general, there was a 38% valuation premium for IPOs compared to listed companies in the sample.
- High valuation levels were influenced by marketing campaigns undertaken by VCs and underwriters and did not seem to be based on financial fundamentals.
- IPOs with negative earnings tended to be valued much higher compared to IPOs with positive earnings (66% versus 19% median valuation premiums), and they had greater levels of press coverage.
- IPOs with VC backing, a high underwriter ranking, small in size and had low leverage, high R&D expenses and high EPS growth rates offered higher valuation premiums. VC backing, underwriter ranking and EPS growth played an important role. Firms with VC backing and high-quality underwriters offered lower margins and greater levels of press coverage.
- Market participants adjusted market prices over time after the IPO. As many of the loss-making IPO companies failed to monetize their high growth expectations over the long term, valuation premiums trended downward to the valuation levels of other IPO companies. As a result, IPO companies with negative earnings underperformed the market and other IPO companies.
- In general, IPOs with negative earnings underperformed 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 could be found (the lockup period typically ends after six months). The underperformance of IPOs with negative earnings was even stronger compared to IPOs with positive earnings after 12, 24 and 36 months.
Another interesting finding was that the percentage of floated shares (out of the total number of shares outstanding) was highly negatively correlated with valuation premiums. This is logical because the smaller supply may act as a signaling device that previous shareholders have confidence in the future. It also reduces agency risks. And the smaller supply itself is a positive. A small float also increases the difficulty and cost of obtaining shares to 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 fueled 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.
There is a large body of evidence on the relatively poor performance of IPOs, particularly the IPOs of smaller companies and those with negative earnings. If you’re considering investing in IPOs and accept their idiosyncratic risks, your investment may well have been driven by overconfidence. 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 not been commensurate with the incremental risks – risks that can be diversified away. As Richard Feynman, one of the 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 the chief research officer of Buckingham Wealth Partners and Buckingham Strategic Wealth.
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