Investing in initial public offering stocks (IPOs) often leads to investors making costly mistakes. Conflicts of interest are just one of the reasons.

How familiar are you with IPO stocks? The IPO or “Initial Public Offering stocks” market—more commonly known as the new issues market—has gone through an extraordinarily bad time in 2022. It’s been bad for all three of the groups that take part in this market. They are as follows:

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Three groups hurt by initial public offering stocks

Investors who put their money in new issues have lost substantial sums in the past year. On average, new stock issues tend to do worse than the rest of the market in their first few years of public trading. In 2022, 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 instance, by August 2021, the new issues market had raised around $100 billion. Up until 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.

2022 will be the worst year for raising money in the new issues market since 2009, when the economy was struggling to pull out of the 2008/2009 recession.

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 initial public offering stocks 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.

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 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.

In 2022, three big special negatives weighed on the market: interest rates and inflation both shot up, and Russia invaded Ukraine. All three 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.

Some of 2021’s new issues may never get back up to the peaks they reached that year—some may go broke. 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 the next six months to a year, I suspect we’ll recommend more recent new issues as buys than we ever have before.

Is there an exception to our IPO rule?

IPOs are more attractive and often easier to obtain when they are part of a privatization effort—when a government sells a government-owned enterprise to investors.

In privatizations, governments often price an IPO at an attractive level that almost ensures that buyers will make money. That’s because governments are less concerned than a private seller would be about getting a good price in a privatization. Instead, they are more concerned about maintaining the goodwill of buyers, for political reasons. Rather than try to get the best price, they may sell a privatization at a good price to a wide range of individual buyers, to win goodwill and votes in the next election.

Use our three-part Successful Investor approach for all of your investments, including initial public offering stocks:

1. Hold mostly high-quality, dividend-paying stocks.
2. Spread your money out across most if not all of the five main economic sectors: Manufacturing & Industry, Resources & Commodities, Consumer, Finance and Utilities.
3. Downplay or stay out of stocks in the broker/media limelight.

How long do you think the IPO market will need to recover from this past year?