Initial public offerings have attracted the attention of investors this year with many large private companies deciding to go public amid the revival of the global economy. Finding lucrative opportunities in this space can prove to be difficult and time-consuming, but rewards far exceed the costs if an effective strategy can be formulated based on fundamentally acceptable reasons. As such, a few necessary components of a successful strategy to get the most out of IPOs will be introduced to help investors approach this market segment correctly.
A quick look at what Buffett has to say
Warren Buffett (Trades, Portfolio), arguably the most successful investor the world has ever seen, has time and again shared his wisdom on various investment topics. The guru opened up about investing in IPOs in an interview with CNBC, saying:
"In 54 years, I don't think Berkshire has ever bought a new issue. The idea of saying the best place in the world I could put my money is something where all the selling incentives are there, commissions are higher, the animal spirits are rising, that that's going to be better than 1,000 other things I could buy where there is no similar enthusiasm just doesn't make any sense."
It's clear that Buffett is not a fan of investing in IPOs and he goes on to list some of the reasons behind his thinking as well. Things, however, took a different turn in late 2018 when Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial) announced an investment in the IPO of StoneCo Ltd. (STNE, Financial), a Brazilian fintech company. The company came to the market at an IPO price of $24 and is currently trading close to $79 as of Dec. 17, implying a staggering capital gain of close to 230% for investors who identified this opportunity early. More recently, Berkshire invested in Snowflake Inc. (SNOW, Financial) in September, which is a cloud computing company that priced its offering at $120 per share. At the current market price of $330, Berkshire is sitting on a healthy gain of 175%.
These investments suggest Buffett might have finally changed his stance on IPOs. Even if the decisions were made by his lieutenants, Buffett was likely involved in the investment approval process at some stage. If there's one thing to learn from the guru's approach to investing in IPOs is that investors should be careful and selective when analyzing opportunities in this space, and that could lead to handsome returns.
Empirical evidence
Even though IPOs attract a lot of attention, historical data suggests many of these companies underperform the broader market and their mature peers in the long run. A study conducted by the University of St. Gallen and the University of Applied Sciences and Arts Northwestern Switzerland found proof of this poor performance, writing:
"We show that a sample of 7,487 U.S. IPOs between 1975 and 2014 continues to significantly underperform mature firms in terms of Carhart-alphas over two years, with underperformance peaking one year after going public. We apply a regression-based portfolio sorts approach (RPS), which allows to decompose the Carhart-alpha into firm-specific characteristics, to explain one-year IPO underperformance using a multitude of market and firm characteristics in a statistically robust setting. In fact, our RPS-model that augments the Carhart factors by a set of firm characteristics related to investments, internationality, liquidity, and leverage can explain IPO underperformance. We find similar results when using the Fama-French three-factor model or an augmented version of the Carhart model."
In an overvalued market, IPOs could become even more expensive. For this reason, investors need to diligently shop for bargains in order to come out on top.
Are we in a bubble?
A few companies that went public this year have had massive success on the first day of trading in U.S. markets, which has prompted some investors to believe the market is in a bubble similar to what we experienced in the dot-com era. Below is a summary of the first-day market performance of a few noteworthy IPOs this year.
| Company | Market performance on the first trading day |
| Airbnb Inc. (ABNB, Financial) | 113% |
| DoorDash Inc. (DASH, Financial) | 86% |
| Palantir Technologies (PLTR, Financial) | 31% |
| XPeng Inc. (XPEV, Financial) | 41% |
Source: Reuters
Investors have aggressively chased high-growth companies following their IPOs, which is evident from the data in the above table. This, however, is not a good enough reason to conclude that we are in a bubble.
A major difference between the dot-com bubble era and today is the average age of a company at the time of its IPO. Airbnb has been operating for more than a decade, Palantir was established 17 years ago and DoorDash was founded over eight years ago. In contrast, some of the best-performing IPOs in the late 1990s involved a lot of young companies that did not have any operating history. Investors betting on today's hot issues, therefore, are assuming a relatively low risk.
That said, some of the recent IPOs have raised the eyebrows of Jay Ritter, a professor at the University of Florida who is well-known for his contributions to the field of IPO analysis. In a Barron's interview, Ritter said:
"We've got this institutional money chasing hot IPOs, pushing up the prices, because of the pattern that money tends to flow into the funds with recent good performance. This is how bubbles form. Investors following momentum strategies, pour money in and push up the prices. We saw this happen in real estate before the bubble started to burst in 2007. We saw it 20 years ago with the internet bubble."
We might not be in a bubble yet, but there are warning signs for investors. Not paying attention to the IPO market is one way to avoid getting burned, but the prudent strategy would be to develop a framework to identify the good from the bad.
Formulating a strategy
Analyzing a company involves assigning the business an intrinsic value estimate that reflects the true state of the company and its earnings projections. Valuation plays a key role in determining the success of an investment, and this is true for both mature and young companies. There is no exception when it comes to IPOs. For this reason, the first step to successfully finding lucrative opportunities in the IPO space is to build an earnings model with conservative assumptions to come up with a realistic market price expectation and then compare this number with the offer price to identify potential mismatches.
Below are two other important metrics that should be included in the analytical framework.
- The ownership percentage of company insiders.
- How the proceeds from the IPO will be used.
Corporate insiders benefit from their deep understanding of the business, and higher ownership among key executives is usually a good indication. Investors can easily find this information by checking the prospectus filed with the Securities and Exchange Commission. Another key factor to consider is the use cases for the funds that would be raised. At times, highly indebted companies decide to tap into equity markets in the hope of raising cash to settle dues, so these companies should be avoided at any cost.
If a company is tapping the market to support growth projects that could deliver positive returns in the long run, it's a good sign for value investors. Carefully going through company filings might not be sufficient to determine whether IPO funds will be used to increase shareholder wealth, however. The best way forward is to conduct industry research to gauge a measure of the macroeconomic outlook for a company and then to assess whether the findings fall in line with management expectations. If a company is overpromising, it's always a bad sign.
Takeaway
Identifying good companies to invest in is difficult. What is even more challenging is finding lucrative opportunities in the IPO market. Approaching this field with the right strategy, however, could lead to market-beating returns in the long run. This year is proving to be red hot for private companies looking to make it big in the market, but investors need to take a step back and carefully analyze the prospects of each issue before jumping on board.
Disclosure: The author does not own any stocks mentioned in this article.
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