Great Mirror of Folly

IFA’s Concerns with IPOs

Disclaimer: This article contains information that was factual and accurate as of the original published date listed on the article. Investors may find some or all of the content of this article beneficial but should be aware that some or all of the information may no longer be accurate. The information and/or data in this article should be verified prior to relying on it when making investment decisions. If you have any questions regarding the information contained in this article please call IFA at 888-643-3133.

Great Mirror of Folly

While some may accuse us of hindsight for writing this blog during the unfolding of the Facebook IPO debacle in which $12.8 billion of shareholder value has been wiped out as of 5/23/2012, Index Funds Advisors, Inc. has long advised our clients not to buy IPO shares after they have hit the market.  Our primary reason is simple and direct—most investors should not buy individual stocks because they offer an expected return that is essentially no higher than the overall market while they subject investors to a substantially higher risk. The table below shows just a few companies whose stock certificates now only have value as obscure collector’s items.

Click to see the full table ...>

Those who are not persuaded by this argument should carefully consider the data on returns received by post-IPO investors. According to an article1 in the Journal of Finance, for 6,249 IPOs from 1980 to 2001, the average total return for the three years subsequent to the IPO lagged the overall market by 23.4%. Most of this lag is attributable to the fact that a large number of IPO companies belong to the category of small cap growth which has shown the worst performance of all the different combinations of size and value. 

Dimensional Fund Advisors (DFA), the company that operates the mutual funds that IFA advises its investors to use, has a longstanding policy of excluding recent IPOs from all their equity strategies.  The reasons cited include the “lock-up” period after which insiders can flood the market with shares that they were previously barred from selling. Furthermore, it is not uncommon for the underwriting bank to intervene in the market to support the price above a certain level, and once that support is terminated, the price can drop precipitously. DFA also excludes companies that fall into the extreme small growth category.

While we at IFA fully accept the concept of market efficiency, we acknowledge that there are situations where the market price may not reflect an unbiased estimate of what the future holds for the company. Stocks within the first year after their IPO are one such situation, and our best advice is to avoid it.

1Ritter, J. R. and Welch, I. (2002), A Review of IPO Activity, Pricing, and Allocations. The Journal of Finance, 57: 1795–1828.