Why IPOs are best avoided

In an IPO (initial public offering), the odds are stacked against you. The seller has more knowledge than you do. So why bother?

912_MW_P14_Strategy

Footasylum: not a great advert for going public

In November last year, sportswear chain Footasylum made its stockmarket debut at a share price of £1.64. On the day of its initial public offering (IPO defined here) the price surged by more than 20%. The firm had a solid pedigree it has been around since 2005 and was set up by the founders of JD Sports, a successful business in the same sector. Yet this week, following its second big profit warning in four months, the share price sits at below 40p, after shedding more than 50% on Monday alone, when the firm warned that profits would be well below the £12.5m it made last year.

It's an illustration of just how badly wrong things can go when you invest in an IPO. Yet while Footasylum is a particularly dramatic example, it's hardly alone. Many studies have shown that, in the long run (over five years and beyond), a strategy of buying stocks at an IPO underperforms tracking the wider market. Academic economists spend a lot of time agonising over why this is an efficient market shouldn't consistently get IPO prices so wrong but common sense explains why.

Investing in an IPO is just like investing in any other listed company, save for two crucial differences. Firstly, information is harder to come by for an IPO because of the lack of public trading history. Secondly, the insiders who know the company best have chosen this particular moment to sell. They may well be hanging on to a stake (Footasylum's founders did), but the point still holds the seller believes that now is a good opportunity to get a good price for their company. Meanwhile, everyone else involved in the process such as the investment bankers making big fees off the deal are highly motivated to make the sale succeed. In short, the cards are stacked in favour of the seller in a way they are not for a company that has already been exposed to the public scrutiny of the stockmarket.

Of course, not all IPOs do badly. The MoneyWeek team is still kicking itself for its negative view of the IPO of internet giant Google (now Alphabet) at the princely sum of $85 a share (now about $1,200), back in 2004. Even so, Google didn't become a 14-bagger overnight you didn't have to invest at the IPO to do well.

And as an investor, I'm in favour of keeping things simple. Successful, thoughtful investing in individual stocks is time consuming. It requires detailed research and analysis. So if you are willing to do all the hard work involved in tracking down a promising company, and you are confident of your ability to do so, then why of all the options already available on the stock exchange would you choose to spend that time analysing an IPO?

Recommended

Things are looking up for income investors as dividend payouts start to rise
Income investing

Things are looking up for income investors as dividend payouts start to rise

UK dividend payouts are ready to grow again, but this crisis has shown why income investors must diversify overseas.
3 May 2021
Equity crowdfunding: a crowded field set to keep growing
Alternative finance

Equity crowdfunding: a crowded field set to keep growing

Equity crowdfunding, a form of early stage business funding, has shaken off the pandemic and is set to keep growing, says David Stevenson
1 May 2021
Tom Slater of Scottish Mortgage: growth, the pandemic, and the importance of optimism
Investment strategy

Tom Slater of Scottish Mortgage: growth, the pandemic, and the importance of optimism

Merryn talks to Tom Slater of the Scottish Mortgage Investment Trust about investing in growth, the pandemic and its aftermath, why optimism will alwa…
30 Apr 2021
Does the old investment adage to “sell in May” still hold true?
Investment strategy

Does the old investment adage to “sell in May” still hold true?

There has long been a saying that you should sell stocks before the summer lull and buy them back more cheaply in the autumn. Dominic Frisby looks at …
28 Apr 2021

Most Popular

What is hyperinflation and could it happen here?
Inflation

What is hyperinflation and could it happen here?

The Bank of England has been accused of the kind of money-printing that could lead to Zimbabwe-style hyperinflation. But that's very unlikely to happe…
4 May 2021
Micro-cap stocks: how to get huge returns from tiny firms
Small cap stocks

Micro-cap stocks: how to get huge returns from tiny firms

Micro-cap stocks are often overlooked, but the British market has plenty of them and their potential is massive. Max King picks the best two investmen…
3 May 2021
Copper has hit a ten-year high, but this could just be the start of a huge bull market
Industrial metals

Copper has hit a ten-year high, but this could just be the start of a huge bull market

The price of copper is at its highest for ten years. But supply constraints and a massive rise in demand mean it’s not going to stop there, says Domin…
5 May 2021