Don’t believe the hype

  By Guest Blogger Doug Rowat

When IPOs make the mainstream news cycles I get nervous. Particularly when the newly listed companies provide services or products that consumers use regularly. Lyft and Levi’s being two recent examples. The media coverage of their IPOs has been ubiquitous. But you ain’t seen nothing yet—just wait until Uber comes to market.

Now rookie investors often assume that if they personally make use of a company’s services or products then that company must be a good investment. Further, if it’s an IPO that everyone’s talking about then there’s also a desire to own it because it’s cool and sexy—bragging rights for dinner parties and family BBQs.

While it’s sometimes true that personal usage = good investment, often this is not the case. Remember phone books and Yellow Pages Income Fund? But, more importantly, there are inherent flaws with the IPO structure that generally make IPOs undesirable long-term investments and, in aggregate, not really all that cool or sexy.

One problem is that many IPO companies are unprofitable with relatively short financial track records and, obviously, no trading history where investors can properly evaluate volatility. Company management also isn’t stupid. Firms want to generate maximum dollar value when proceeding with an IPO, so you can bet that market conditions are going to be just about perfect when an IPO is filed. This is one reason why there were almost US$20 billion in energy sector IPOs in 2008 when oil averaged almost US$100/barrel versus only US$13 billion last year when oil averaged US$65/barrel. Companies come to market when the odds, and market sentiment, are heavily stacked in their favour. But what this means for IPO investors is that they’re often buying at the top.

No surprise then that IPOs overall really don’t perform all that well longer term. The godfather of IPO research is Professor Jay Ritter of the University of Florida who’s been looking at IPO data going all the way back to the 1980s. Excluding the first day of trading, IPOs underperform firms of similar market cap by 3.3% annually on average in the first five years post their initial listing. Ritter’s performance data is also confirmed by simply comparing the Renaissance IPO Index, a benchmark that captures 80% of newly public US companies, versus the S&P 500. Again, IPOs significantly underperform. Basically, for every Amazon.com there’s a Pets.com.

Renaissance IPO Index (white line) vs the S&P 500 (orange)

Source: Bloomberg

Now, it’s true that IPOs usually do have great first trading days—all that built up hype and momentum finally explodes on Day 1. However, the truth of our industry is that for the hottest IPOs it remains almost impossible for an average investor to get their hands on a share allocation before trading begins. Like Yeezy Turtledove Ultraboosts on launch day at Foot Locker—you can line up, but you ain’t getting any. Further, even if a retail investment advisor were to somehow get their hands on a small allotment of hot IPO shares, they’re, in all likelihood, only going to give a taste of this sugar to their biggest clients.

And, in our view, that’s just not fair.

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Finally, Garth and I don’t consult in any way on what we write in our blog posts, but clearly there’s a common thread to our thinking. A shared brain, if you will. Here’s some proof. Below is an excerpt from one of Garth’s recent posts followed by one of mine. Note the similarities. Garth and I have been to all the market rodeos and have seen all aspects of investor (mis)behaviour. So, listen to us, we know of what we speak. First, Garth:

…let’s acknowledge humans love to think they live in unique times. At heart we’re drama queens. We believe current forces are overwhelming and the outcome will be epic. Therefore we must take extraordinary action. In fact, every time stock markets correct folks panic and think they’re going to zero. They rush into cash, often triggering losses on assets that soon rise again. Fools. But that’s us. We never learn.

And an excerpt from one of my blog posts:

…another interesting truth about investor behaviour is that investors often feel that the world events that they’re encountering right now are the most significant and consequential in all of history. This is pure vanity.

The Cuban missile crisis, the JFK assassination and the escalation of the Vietnam War in the 1960s; the energy crisis, massive US trade deficits and a 10%+ US unemployment rate in the 1970s; a US recession, the attempted assassination of Ronald Reagan and Black Monday in the 1980s; the Gulf War, another US recession, the Asian financial crisis and Y2K in the 1990s; the ‘tech wreck’, 9/11, two more recessions (one massive) and corporate accounting scandals of the 2000s—all of these events weren’t significant? This is to say nothing of the Great Depression, World Wars and atomic bomb drops in even earlier decades. Yet despite all this turmoil, the market advanced and long-term investors made money.

Our current situation is not particularly special. In fact, we’re fortunate that no major countries are at war, capital markets are doing well and the global economy is actually quite stable. While risk is always present, it’s really no more severe than it’s been in the past. We just feel that our brand of uncertainty is the worst that the world has ever seen and we make investment errors as a result.

So, maintain a balanced and diversified portfolio, ignore the distractions, relax and go about your life. But you say that you’re special and the times that you live in are the riskiest the world’s ever seen?

Wrong. Get over yourself.

Doug Rowat, FCSI® is Portfolio Manager with Turner Investments and Senior Vice President, Private Client Group, Raymond James Ltd.