The Drop in the IPO Market Has Hurt Three Main Groups. But What’s the Outlook Going Forward?
The IPO market, or “Initial Public Offerings” market—more commonly known as the new issues market—has gone through an extraordinarily bad time the last couple of years. It’s been bad for all three of the groups that take part in this market. They are as follows:
- Investors who put their money in new issues have lost substantial sums in the past couple of years. On average, new stock issues tend to do worse than the rest of the market in their first few years of public trading. The last two years or so, they performed much worse than ever.
- Financial institutions that bring new issues to market for sale to investors have suffered, too, because demand for new issues has dried up. For example, in the first eight months of 2021, up until the end of August, the new issues market had raised around $100 billion. Through August 2022, it had raised just $5 billion. In the past quarter century, the new issues market raised an average of $33 billion at that point in the year.
- Companies that raise capital for themselves through the new issues market are suffering as well. When the new issues market began drying up as a source of corporate funding, many would-be issuers of new stocks found it was harder and more expensive than ever to find alternate sources of financing.
As long-time readers know, we generally advise staying out of new stock issues. After all, there’s a random element in the success or failure of every business, especially when it’s just starting out. But new issues expose you to a special risk that you avoid with stocks that have been trading publicly for some time. That is, you can only invest in new issues when they come to market.
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This is just one more example of a conflict of interest, which we’ve often referred to as the worst source of risk you face as an investor.
Companies only come to the new issue market to sell their stock when it’s a good time for the company and/or its insiders to sell. The insiders can’t predict the future, of course. However, they do know much more than outsiders do about their company.
New issues in the IPO market also come with one additional negative factor: it costs a lot of money to convert a private company into a publicly traded new issue. These costs include substantial legal and accounting fees, plus brokers’ commissions and other marketing expenses. These new-issue costs come out of the funds supplied by the new issue buyers.
To top it off, typical new issue buyers/traders know about these negative factors, in many cases from bitter experience. They take them into account when deciding when to sell. This raises new-issue volatility.
Recently, four big special negatives have weighed on the market: interest rates and inflation both shot up, Russia’s invasion of Ukraine and the Israeli-Palestinian Conflict. All four issues were bound to weigh on the market generally, but especially so for risky and volatile market segments such as new issues.
Our view now is that a diversified portfolio of high-quality stocks is likely to gain in value over the next year or longer. However, a portfolio like that should include little if any exposure to recent new issues.
Before buying, the best thing to do is wait and see how your favourites perform in the next upturn in the stock market and/or the economy. In fact, sometime soon, I suspect we’ll recommend more recent new issues as buys than we ever have before.
Better Than New Stock Issues: Spinoffs
When a company carries out a spinoff, it sets up one of its subsidiaries or divisions as a separate company, then hands out shares in the new company to its own shareholders. It may hand out the shares as a special dividend, or give its shareholders an opportunity to swap shares of the parent company for the shares of the newly established spinoff.
Study after study has shown that after an initial adjustment period of a few months, spinoffs tend to outperform groups of comparable stocks for several years. (For that matter, the parent companies also tend to outperform comparable firms for several years after a spinoff.)
Spinoffs make more sense than IPOs for a few reasons:
- An IPO is the initial sale of stock by a company as it goes public. Initial public offerings often have a turbulent start on the stock market. Shareholders often sell a portion of their shares to recoup their investment during the first weeks and months that the stock begins trading. We generally advise investors to stay out of IPOs.
- Company managers naturally prefer to acquire or expand their assets, not get rid of them. Getting rid of assets reduces a company’s total potential profit. This cuts into the funds available to pay managers, and reduces their opportunities for career advancement. The management of a parent company will only hand out a subsidiary to its own investors if it’s nearly certain that the subsidiary, and the parent, will be better off after the spinoff than before.
- Spinoffs involve a lot of work and legal fees than IPOs. The parent will only spin off the unwanted subsidiary if it can’t sell the stock for what it feels it’s worth. That’s why companies only have an incentive to do spinoffs under two sets of favourable conditions: When they feel it isn’t a good time to sell (which often means it’s a good time to buy); or, when they feel the assets they plan to spin off will be worth substantially more in the future, possibly within a few years.
We’ve had great success with a number of spun-off stocks over the years. That’s especially true of the many spinoffs we have recommended that have gone up after they began trading, and have later attracted a takeover bid at a substantial premium over the market price. On the whole, in investing, spinoffs are the closest thing you can find to a sure thing.
What do you think of the current IPO market?