Topic: Spinoffs

The odds are stacked against you when investing in IPOs

investing in ipos

Investing in IPOs may seem like a quick way to make money—but studies show that the reality is quite different.

Human nature puts the odds against you when investing in IPOs or Initial Public Offerings (we also refer to them as new stock issues).

Insiders decide when to bring a new IPO to market. They mostly do so only when it’s a good time for the company or its insiders to sell stock to the public. That means IPOs tend to come to market when the company or its industry is enjoying what may be a temporary improvement in its business or profit. If the improvement is only temporary, this generally isn’t a good time for you to buy.

They outperform comparable stocks for years

“We can say without reservation that, in investing, spinoffs are the closest thing you can find to a sure thing. It all comes down to the incentives when companies spin off a subsidiary or division and hand out shares to their shareholders. 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….” Pat McKeough shows how spinoffs and other “special situations” can create windfalls for informed investors.

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Investment industry practice makes things worse. Financial institutions know how to package a IPO to make it seem like a great deal. This tends to raise the price that you pay for a IPO, compared to a stock that is already trading in the market. That’s a second reason why investing in IPOs tend to be overpriced in relation to a balanced assessment of their prospects. In addition, the underwriting process adds costs, for commissions (usually 5% to 7% of the funds raised), plus legal and accounting expenses.

Long-term studies show that, on average, IPOs tend to do worse than comparable stocks over a variety of time periods.

Professor Jay R. Ritter of the University of Florida recently updated his long-time study of more than 7,000 IPOs that came on the market in the U.S. from 1980 through 2013. He studied returns on the IPOs for the first five years after issue, in two ways.

The average yearly return over five years on the IPOs was 3.1% below the return on existing stocks with the same market capitalization (or “market cap”, the value of all stock each company had outstanding). When Professor Ritter matched the IPOs with existing stocks that had comparable ratios of book value to market value, the IPO’s performance shortfall shrank to 2.0%.

Both comparisons in the study show that IPOs actually beat existing shares in the first six months of trading. That’s when “hot IPOs” (new IPOs that shoot up in price the moment they come on the market) have their biggest impact, and bring up the average new issue performance. However, hot IPOs are generally unavailable to the average investor.

That’s why we rarely if ever recommend investing in IPOS when they first come out. We do make exceptions to this rule from time to time. In 2006, for instance, we advised buying Tim Hortons as an IPO. We felt the U.S. target audience for the stock would fail to understand the concept as well as Canadians. It seems we were right, and Tim’s was a great performer for us.

We generally hold off on recommending investing in IPOs until they’ve been trading publicly for at least several years. The best general rule for conservative investors is to hold off on buying new issues until they have survived a recession and seem to be participating in the recovery. However, this rule simply reflects the odds against new issues, based on the historical record.

There is 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.

A corporate spin-off versus an IPO

While investing in IPOs usually results in poor returns, investing in a corporate spin-offs are the closest thing we know of to a “sure thing.”

A number of studies have shown that after an initial adjustment period of a few months, spin-offs 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 spin-off. That above-average performance makes sense for a couple of reasons.

Corporate spin-offs involve a lot of work and legal fees. 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 spin-offs 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.

Have you had a successful track record when in investing IPOs in the past? Care to share your triumphs or your tribulations? Share your experiences with us in the comment section.


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