From Gerd Kommer and Marcel Lauterwasser
Many interesting results of scientific financial market research do not reach the magical 100% threshold in terms of their “degree of reliability”. Then there is the possibility that the investment conclusions formulated therein will later turn out to be wrong (although this is no different in other research disciplines such as medicine). In this blog post, however, we present a practice-relevant finding from financial market research, the degree of reliability of which is probably very close to 100%. It is said:
The return on IPO stocks (IPO = Initial Public Offering) during the first twelve up to 24 months after their listing is statistically significantly below the general market return. At the same time, the volatility (a measure of risk) of IPO stocks tends to be higher than that of the general market. Statistically speaking, IPO stocks are therefore clear underperformers.
The trustworthiness of this insight from empirical financial market research can be considered high because (a) to our knowledge there is no academic study that fundamentally denies it, (b) the results of the existing studies are also quite clear, e.g. B. a high degree of so-called statistical significance and (c) the economic logic behind this empirical observation is also convincing.
In this blog post we will show how severe the underperformance of IPO stocks is, what its economic causes are, what additional facts one should consider when assessing this research result and what it means for the practice of a private investor.
This is how poorly IPO stocks pay
First of all, to quantify the underperformance of IPOs: Although the under-return of IPO stocks in the US stock market has been clearly proven in numerous studies over the last 50 years, it is not entirely easy to representatively summarize this under-return in a single or a few numbers. The main reason is that in the many studies on IPO stocks, different analytical approaches are often used. They also refer to different time periods. Nevertheless, we can state that based on the studies we have evaluated, the average under-return over the first twelve, 24 or 36 months after the IPO is typically more than two percentage points per year (Ritter 1991, Hoechle et al. 2021, Siev/Quadan 2022).
A current indication of this structural underperformance is provided by the (so far) only IPO ETF that is offered on the German ETF market First Trust US IPO Index UCITS ETF (WKN A14X88). The ETF replicates the “IPOX-100 U.S. Index”. This includes the hundred largest US IPOs in terms of market capitalization during their first 1,000 trading days, i.e. up to around four years after the IPO. The First Trust ETF was launched eight years ago in October 2015. From then until September 2023 it produced a return of 8.1% p.a. (in euros). This is over one percentage point p.a. less than the US small cap market in the form of, for example iShares S&P Small Cap 600 UCITS ETF (WKN A0Q1YY) delivered (9.2% p.a.). In terms of risk (volatility and maximum drawdown), the two ETFs were equal.
There is also evidence of a statistical under-return from IPOs for the small German IPO market (Kirchner 2019, Kirchner 2022).
Of course, among the thousands of IPOs that have taken place worldwide since the mid-1970s, there are many isolated cases of market-beating returns in the first 12 to 36 months post-IPO. However, this does not change the surprisingly unanimous finding in research that IPOs collectively produce a clear absolute and an even clearer risk-adjusted under-return.
We believe it is unlikely that there is a method to identify the minority of positive IPO exceptions sufficiently reliably in advance, but for reasons of space we will not go into this point in more detail here.
The causes of IPO underperformance
What are the economic reasons for IPO underperformance? Several possible reasons are cited in the literature, all of which presumably contribute to the under-return of IPOs. The main causative factors include the following three:
Reason 1 – Strategic IPO Timing: Investors are over-optimistic about the prospects of IPO shares, which are regularly covered intensively and often in a very blatant manner in the financial media, while the sharessalesperson (the pre-IPO shareholders) tactically exploit this tendency to overestimate by timing the IPO date so that it coincides with a particularly good phase for the IPO company in terms of business and market sentiment. The IPO takes place at the “peak”, so to speak, when everything is going “particularly well” and the naive over-optimism of many potential investors is therefore most pronounced. The probability of an economic deterioration immediately after such a peak is naturally higher than the long-term average.
Reason 2 – Lockup agreements: In the majority of all IPOs, there are so-called lockup agreements (limited resale bans) for many buyers who are within the framework of the Initial allocation Receive shares (see our comments below on the important aspect of “initial allocation”). These lockups, which typically last twelve months, often affect up to half of the company's shares in IPOs. When the ban on sales ends a year later, many stocks suddenly flood the market. This can lower the price and therefore reduce the return up to that point.
Reason 3 – Harmful Factor Exposure: IPO shares fall into the equity segment more often than average Small Cap + Growth (high valuation stocks) + Low Profitability + High Asset Growth (high recent total assets growth). This four combination of structural features is considered by researchers to be a type of stock with below-average returns. To put it casually, you could put it this way: IPO stocks tend to be so-called Lottery stocks, i.e. lottery-like stocks that have a very high probability of weak returns and a very low probability of spectacularly high returns (hence the term lottery). However, the average realized return of this equity segment is worse than that of the market.
Important additional facts about IPOs
In order to adequately understand the statistical underperformance of IPO stocks, it is also worth knowing the following facts, which are not widely known:
The typical scientific study of the returns on IPO shares uses the closing price of the first day or - depending on the study - the first month-end after the listing as the starting price (price). This initial closing price should not be confused with the IPO offer price, the “IPO price”, which is reported in the media and at which the share is placed on the market, i.e. h. at which those investors who receive a certain quota of shares as part of the “initial allocation” buy the shares.
For the period 1980 to 2022 (43 years), an average first-day return of 19.0% was determined for IPOs in the USA (Ritter 2023). If this “pop return” on day one until the close of trading were included in the return studies, the statistical under-return of IPOs would be lower. Nevertheless, not taking the day one pop return into account in scientific studies on the performance of IPOs is correct, as a normal investor (institutional or private) does not receive an initial allocation. These shares are not sold freely, as is otherwise the case on the stock exchange. All or at least the majority of the initial allocation quotas usually go to management members of the company, to the “underwriter banks” (which manage the IPO and undertake to “price maintenance” for some time afterwards, which is risky for these banks) and other institutional investors who are close to the pre-IPO shareholders (Jenkinson et al. 2018).
When examining the performance of IPO stocks, one must differentiate between short-term underperformance and long-term underperformance, i.e. return and risk in the first twelve to 36 months after the IPO as distinct from return/risk during the first ten to 15 post-IPO years. The statistical under-return of IPOs is more pronounced in the short term than in the long term and, not surprisingly, in the very long term it disappears completely.
In general, the number of IPOs has decreased over time in developed markets over the past few decades, while it has increased in emerging markets. A similar phenomenon can also be seen in relation to the total number of all listed companies. This has been falling for around 30 years in the developed markets (particularly pronounced in the USA) and increasing in the emerging markets. The main reason for the decline in the developed markets is the increasingly strict and therefore more expensive listing and transparency rules that listed companies have to comply with, while at the same time the global private equity market - the most important non-listed alternative to raising equity capital - has become larger and more liquid in recent decades.
The implementation of this IPO knowledge in practice
How can these research findings be used in practice as a private investor?
In our opinion, stock pickers who invest in individual stocks should think twice about purchasing IPO shares in the 12+ months after the IPO. Particular caution should be exercised with IPOs that fall into the lower size range, i.e. less than a billion euros or dollars in the company's market capitalization. For these companies, the short-term underperformance is statistically even more pronounced than for large IPO companies.
There could be a reason to deviate from this rule of thumb if, in exceptional cases, the private investor managed to get hold of a contingent of IPO shares as part of the initial allocation.
There are currently around 1,600 stock ETFs available for ETF investors in the German-speaking market. To our knowledge, only one of them fundamentally excludes IPO titles. This is the one – watch out for advertising – L&G Gerd Kommer Multifactor UCITS ETF – WKN WELT0A (accumulating) or WKN WELT0B (distributing). Of course, the IPO exclusion for the first twelve post-IPO months of our “World AG ETF” is not its most important individual feature, but one that - like several other exclusion criteria - should contribute to an attractive long-term return-risk combination. Further information about the GK ETF is available here.
The general exclusion of IPO stocks is an easy-to-implement way to increase the expected return on a diversified stock investment. From our perspective, it is surprising that this rarely happens in both actively and passively managed portfolios.
The tips and information in this blog post provide not investment advice or recommendations for the purchase or sale of securities. They are for personal information only and reflect the opinion of the author. If the reader adopts the contents of this newsletter, he is aware that he is acting independently and bears responsibility for this. Liability, even in individual cases, is excluded.
literature
Black, Stanley/Kevin Green (2019): “What to Know About an IPO”; Working Paper; Dimensional Fund Advisors
Gupta, Vartica et al. (2021): “Reports of corporations’ demise have been greatly exaggerated”; McKinsey & Company; Oct. 2021; Internet reference: here
Hoechle, Daniel/Larissa Karthaus/Markus Schmid (2021): “The Long-Term Performance of IPOs Revisited”; May 27, 2021; Internet reference: Social Sciences Research Network SSRN
Jenkinson, Tim/Howard Jones/Felix Suntheim (2018): "Quid Pro Quo? What Factors Influence IPO Allocations to Investors?"; In: The Journal of Finance; Vol. 73
Kirchner, Christian (2019): “60% flops: The horror record of the Frankfurt IPO banks”; May 26, 2019; financial scene information service, see here
Kirchner, Christian (2022): “What blame our banks bear for the German IPO disaster”; September 6, 2022; financial scene information service, see here
Ritter, Jay (1991): “The Long-Run Performance of Initial Public Offerings”; In: The Journal of Finance; 46; Issue 1; March 1991
Ritter, Jay (2023): “Initial Public Offerings: Underpricing”; Working paper; Internet reference: https://site.warrington.ufl.edu/ritter/files/IPOs-Underpricing.pdf
Siev, Smadar/Mahmoud Qadan (2022): “Call Me When You Grow Up: Firms’ Age, Size, and IPO Performance across Sectors”, Journal of Risk and Financial Management; 2022 Vol. 15; No. 12
Swedroe, Larry (2022): “The Dismal Track Record of IPOs”; Nov 14, 2022; Internet reference here
Zhang, Feng (2023): “Non-Random Survival and Long-Run IPO Underperformance”; July 25, 2023; Internet reference: Social Sciences Research Network SSRN