Don't let IPO buzz cloud your judgment

Initial Public Offerings (IPOs) tend to attract a lot of investor interest, especially when the company is well-known. However, that excitement isn’t always matched by investment returns. Before you make an investment decision, it’s important that you research the company and determine whether its stock would be a good fit for your investment strategy and portfolio. This due diligence can be particularly important when you’re familiar with the company; however, though familiarity can mean comfort, you should review the company as objectively as possible.

IPO excitement fades fast

The stock price of an IPO tends to rise on the day it begins trading. Historically, the average first-day return has been 18%.* However, investors who bought shares at the end of the first day didn’t always fare as well.

IPO stock prices can be extremely volatile, since frequently there is little financial information about the companies and they may not yet be profitable. In many cases, investor excitement drives short-term changes in the stock prices because the initial demand outpaces the supply of shares, but excitement appears to fade quickly after the first day. This is why IPO stocks have underperformed compared to those of similar companies.

Familiarity isn't enough

In recent years, many consumer-facing technology companies have had IPOs. Many provide familiar services and products, yet their investment performance was similar to the overall IPO performance of the past 10 years. Their stock prices generally rose sharply on the first day of trading, but in almost every case, their stocks had fallen below their closing first-day price within six months.

The price performance of 25 consumer-facing technology companies following their IPOs is illustrated in Figure 1 (below). On average, these stocks experienced a 30.8% price increase on the first day of trading, reflecting the excitement-driven demand often associated with high-profile IPOs. However, in the three- and six-month periods following the first-day close, these stocks, on average, experienced declines between 6.4% and 11.2%.

25 IPOs: Stock price performance during first 180 days

Figure 1. Price Performance of 25 Technology IPOs between 2011 and 2019
Source: FactSet. Edward Jones does not follow any of these companies, except for Facebook (Buy). Past performance is no guarantee of future results.

Even if you are familiar with a company’s products from a consumer standpoint, as an investor you should make sure you research its prospects and valuation before making an investment decision. While it’s a positive sign for markets when companies go public, buying their stock may not be the right investment choice for your portfolio.

If you’re hearing buzz about an upcoming IPO, remember to take a step back and determine whether the company’s stock makes sense within your portfolio and overall investment strategy. Your financial advisor can provide insights and recommendations to help you determine what investment choices will help keep you on track toward your financial goals.

*Source: Professor Jay Ritter, “Returns on IPOs during the five years after issuing, for IPOs from 1980-2015”; “Initial Public Offerings: Updated Statistics”; http://bear.warrington.ufl.edu/ritter/.