Initial public offerings of stock (IPOs) offer a bundle of appealing attributes, as they often represent a new company in a hot industry with unlimited growth potential. As institutional investors usually get first dibs at these offerings, retail and individual investors often feel left out, especially if prices skyrocket immediately following pricing. A closer look at today’s IPO market should reassure investors that patience and waiting for the stock to settle down may be the best course of action.
Today’s market has seen a plethora of IPOs, with varying degrees of success. Beyond Meat (BYND) hit a triple and pet online retailer Chewy (CHWY) surged 64%. On the opposite end of the spectrum, Lyft (LYFT), traded as much as 30% below its offering price and its competitor Uber (UBER) immediately fell 11% below its debut. This clearly shows an IPO market that is Jekyll and Hyde in nature: welcoming to some but unforgiving for those who fall short.
For investors who are used to IPO gold, today’s unforgiving IPO market leaves many confused about what is different. The answer lies in the modern metrics of valuation and the structure of the market.
Today’s Valuation Metrics are Creative – Both Uber and Lyft became creative when touting their performance, hoping to override their lack of profitability by promoting their role as industry disruptors. That was a necessary, if not transparent, move as the two companies debuted with the largest ever 12-month loss for a U.S. company preceding an IPO. Both companies focused on a metric which ignored significant operating expenses, defining varios versions of “contribution profit.”
While it is reasonable to believe high start-up costs are necessary to position a company well for future profitability, investors would be wise to not take their eye off that tried-and-true Generally Accepted Accounting Principles (GAAP) ball. Analyze closely the reconciliation to that standard the company must provide.
The Big Institutional Players Run the Show - Many start-up companies tap large institutional firms for early, pre-IPO financing. These initial lenders count on a new set of investors to help them realize their profit through the IPO. However, in the case of Uber, the company already had the honor of being the most richly funded private technology company. Many of the usual institutional investors who would step in and buy at the public offering stayed seated, as they already felt they had adequate exposure. Some even elected to reduce their ownership and offer shares to the public, further weakening aftermarket pricing. If the trend continues where start-ups wait longer to go public and maximize private funding, the aftermarket may not be as deep as it has been historically.
The Supply and Demand Relationship is Key - In many cases, the initial price run-up is not indicative of where the stock will ultimately end up. There is a fair amount of psychological warfare that goes on in the immediate aftermath of an IPO resulting in the “I want it now” mentality. Prices often stabilize after the initial hype.
Don’t always judge a company by how its IPO does in the first few months. The most famous example of this is Facebook (FB), whose shares plunged more than 50% from its offering price in the first four months following its May 2012 IPO. Clearly, that company went on to achieve great success. Steering clear of the initial investment fury and waiting for the stock to settle down may be the smart strategy.
For most individual investors, the best practice on how to play the IPO market involves patience and diligence. Wait for the company to settle into a trading range, as prices usually fall back to earth. When deciding to invest in a newly public company, keep focused on its business prospects and paths to profitability. Ask the questions that might cause concern: are there growing losses, what are the barriers to entry for other competitors, how solid is corporate governance and what is the valuation? Check the reconciliation to GAAP standards and make sure you are comfortable with the logic. In other words, know what you are buying.
Note: Elaine Phipps, MBA, CFA, is a Portfolio Manager at Point View Wealth Management, Inc., a registered investment advisor at 382 Springfield Ave., Summit.
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