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Why You Should Not Invest in IPOs

Many investors usually like to invest in an initial public offering, or IPO for short, due to the fear of missing out (FOMO). They may feel that if they are not investing some money in a company that is set to go public, they could miss the boat and not get a great investment opportunity again. There are stories abound about impressive IPOs that have gone on to create massive wealth for early investors.

Some investors like to invest in IPOs as they see them as a sure way to make a quick buck. Such investors subscribe to the idea of applying for an IPO during its offer period and selling the shares at a higher price once the stock starts trading.

Most IPOs underperform

Since 2012, there have been more than 130 IPOs in Singapore’s stock market, with the majority of them ending on a positive note on their first trading day. But, if we stretch the time horizon, the results are totally flipped: Most of the IPOs since 2012 are currently trading at a price lower than their IPO price. They have become losers.

The data above gels well with the numbers I shared in an earlier article of mine: The stocks that were listed at the start of 2018 through to 7 August had share prices (as of 7 August) that were lower than their respective IPO prices. The third-best performing stock in that IPO-batch – Jawala Inc (SGX: 1J7) – was, in fact, trading underwater.

So, when it comes to probability, the odds of making money for the long-term by applying for an IPO is low. Investors are better off being patient and investing in the companies post-listing.

High valuation

One of the reasons for a company to list on a stock exchange is to allow its current investors — such as its founders, private equity firms, and large individual investors — to “cash out” part or all of what they have invested.

Therefore, IPOs may be sold at prices far higher than the economic value of the underlying businesses. This is to get the maximum return for the key stakeholders of the soon-to-IPO company.

No one would buy a jacket for $50 if it’s only worth $10. So why should investors buy IPOs that are far overvalued?

Quotes galore (and the lessons within)

Billionaire investor Warren Buffett once wrote in his 1993 letter to shareholders (emphases are mine):

“[An] intelligent investor in common stocks will do better in the secondary market than he will do buying new issues… [IPO] market is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavourable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of public offering or in a negotiated transaction.”

As seen earlier, the historical data indeed show that investors are better off investing in stocks in the secondary market (referring to the stock market) and not on the primary market, as is the case with IPOs.

Most companies tend to list when the stock market is doing well. There have also been instances when IPOs have been called off when market sentiment was not that great. Without a buoyant mood in the market, IPOs tend to perform poorly on their debut.

Professor Sanjay Bakshi, in his article entitled The Economics of IPO (and other) Markets, wrote:

“Four characteristics of the IPO market makes it a market where it is far more profitable to be a seller than to be a buyer. First, in the IPO market, there are many buyers and a only a handful of sellers. Second, the sellers, being insiders, always know more about the company whose shares are to be sold, than the buyers. Third, the sellers hold an extremely valuable option of deciding the timing of the sale. Naturally, they would choose to sell only when they get high prices for the shares. Finally, the quantity of shares being offered is flexible and can be “managed” by the merchant bankers to attain the optimum price from the sellers’ viewpoint.”

He added:

“But, what is “optimum” from the sellers’ viewpoint is not the “optimum” from the buyers’ viewpoint. This is an important point to note: Companies want to raise capital at the lowest possible cost, which from their viewpoint means issuance of shares at high prices. That is why bull markets are always accompanied by an surge in the issuance of shares.”

The Foolish bottom line

Not all IPOs are bad, and I’m certainly not tainting all IPOs with the same brush. There could be some IPOs that are done for altruistic reasons, and there are some that will be huge winners over the long run. What investors should do is to invest in stocks based on thorough research and not invest in a stock based on hype and sentiment alone. FOMO must not be a reason to buy an IPO.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.