General Motors (GM) roared back onto the stock market on Nov. 18 with what could go down as the largest public offering ever. That marquee sale comes amid the busiest week for initial public offerings, or IPOs, since before 2008's financial crisis. But an analysis conducted for Businessweek.com by Bloomberg Rankings shows just how risky IPOs can be for the individual investor.
In the IPO market, fortunes can be made on the first day of trading. GM will raise as much as $23.1 billion by selling shares that began trading Nov. 18. Also premiering this week are shares of consulting firm Booz Allen Hamilton (BAH), circuit maker Aeroflex Holding (ARX), and securities broker LPL Investment Holdings (LPLA). Since 2005, at least 50 prominent U.S. initial public offerings have risen 35 percent or more on their first day of trading, according to Bloomberg. Some jumped far higher, including commodity exchange operator Nymex Holdings (NMX), which rose 125 percent when it made its debut on Nov. 17, 2006, and Chipotle Mexican Grill (CMG), which doubled on its first day of trading Jan. 26, 2006. For a list of the 20 biggest blockbuster IPOs since 2005 and more on the methodology, click here.
Those price pops are bound to catch your attention. Yet very few individual investors have the influence or resources to get shares of hot IPOs before they go on the market. "It's easy to get IPOs that no one else wants to buy, and it's very difficult to get IPOs that there is strong demand for," says Jay Ritter, an IPO expert and finance professor at the University of Florida in Gainesville.
Instead, retail investors are forced to buy shares after they start trading. According to Bloomberg Rankings' analysis, the results of chasing IPOs with big opening days can be very disappointing.
For the 50 biggest blockbuster IPOs since 2005, the average return on their first day was 56 percent. If you were an investor who bought those stocks a week after their IPO, however, and held them for a year, you would have lost an average of 5.6 percent. (Bloomberg Rankings analyzed performance starting five days after an IPO to factor out the wild volatility that can hit new stocks in their first week.)
That doesn't mean all IPOs are bad investments. All 455 IPOs that met the same criteria—including many with mediocre first-day returns—would have returned an average of 18.7 percent in their first year. From 2005 to 2009, the FTSE Renaissance IPO Composite Index, which includes a basket of U.S. IPOs within two years of listing, returned an average of 12.1 percent per year.
It is a well-known fact among IPO experts and traders—if not among individual investors—that the IPOs that are most successful initially often underperform over the long term. Josef Schuster, founder of IPOX Capital Management and portfolio manager of the Direxion Long/Short Global IPO Fund, says he automatically excludes from his IPO holdings those stocks that jump 50 percent or more in initial trading. "You can save by avoiding those companies," he says. Those companies "are the highest risk over the long run."
One problem is that blockbuster IPOs are "fundamentally expensive," Schuster says, meaning that investors are often paying a lot compared with other companies with similar profits and sales.
Expectations for many of these stocks start out so high that they're quite difficult to meet, says Scott Sweet, senior managing partner at research firm IPO Boutique. Therefore, despite such high-profile exceptions as Chipotle and Google (GOOG), "many [stocks] that have had spectacular first-day debuts have tumbled" later, he says. In early trading, hot IPOs attract buyers whom Sweet characterizes as short-term "renters" of the shares, rather than long-term stockholders. "They only wait for the 'pop,' and out they go onto the next," he says.
Some of the riskiest IPOs turn out to be companies that aren't fully baked. Ritter's research shows that the most chronic underperformers in the IPO market are those with less than $50 million in sales. "Avoid companies that have not already demonstrated an ability to generate revenue," he says.
The draw for many investors, of course, is that once in a while "high risk" converts to "high return." Of the 20 IPOs with the biggest first-day pops identified by Bloomberg Rankings, just eight offered investors a positive one-year return. The most successful, however, were wildly so—such as Under Armour (UA), which, even after a 95 percent jump on its debut on Nov. 18, 2005, doubled the following year.