IPOs often generate lots of excitement—do they also generate investor profits?
Sometimes, but Warren Buffett stays away.
Initial public offerings (IPOs) create buzz in the investment world. After all, who doesn’t want “in” on the ground floor of the next Microsoft, Google or Amazon? But, it’s easy to forget that this was the mentality that fueled the dotcom bubble. Investors drove the price of IPO stocks for hundreds of unproven internet companies up because they wanted to make a quick buck and were afraid of missing out!
To be clear, we don’t think the current IPO environment is like it was twenty years ago, but the IPO buzz is well and truly back. Ridesharing giants Uber and Lyft already completed offerings, and investors are anticipating several others, such as Airbnb, as well as many less-known names. The IPO market is heating up largely because the stock market is strong, and companies like to sell shares into a rising market.
But what does this mean for you as an individual investor? Should you buy into the hype around IPO stocks, or should you steer clear?
IPO Stocks: Are They Good Investments?
If old adages are to be believed—the early bird gets the worm. But sticking your beak blindly in every dark hole you see could be a risky endeavor. So, exercise some patience and caution if you are an early investor going for that worm!
In fact, in a widely publicized interview with CNBC after his annual Berkshire Hathaway shareholder meeting this year, Warren Buffet warned against ordinary investors investing in IPOs. And he must count himself among the “ordinary” because he revealed that he hasn’t invested in an IPO since Ford Motor company’s debut in 1955.
The reality is that typically, only institutional investors and the top clients of full-service brokerage firms have access to shares of hot IPOs at the offering price. If you are an everyday investor, you would instead buy shares on the secondary market, the stock exchange. If the IPO is highly successful, shares may rocket past the offering price on the first day of trading, which is good for initial investors, but dicey for those buying on the secondary market.
Before buying a highflying new stock, consider the basis for its share price. Because there is minimal information available, new IPOs trade mostly off investor speculation and not fundamentals. There is especially high volatility in the first few days of trading because the stock goes through an initial period of price discovery (the process of setting the proper price of a security) in the market. After the initial frenzy, it’s not uncommon for the new stock to settle at a lower price, at least for the time being. But if you plan to buy early before the company has any sort of established track record, be aware that the wild ride will probably continue for the foreseeable future.
Is There a Better Time to Buy Into a Newly Public Company?
If you are interested in the long-term prospects of the new company and you can muster some patience, it’s probably best to consider waiting at least until trading has settled down and more objective information is available on the company’s financials and market prospects.
For those with just a little patience, one relatively fast milestone is the expiration of the “lockup” period, or a window of time where investors are not allowed to redeem or sell shares. This means that company insiders can’t sell the stock they were issued until a specific amount of time after the IPO. This period is usually between 90 and 180 days, but a little research will help you learn the exact agreement for a specific company.
After that period ends, watch what happens. If insiders are selling like crazy, it may be an early indicator that the stock is overpriced (or at least insiders think so), or that there are other potential red flags around the company’s long-term prospects. This doesn’t always mean danger, as insiders may sell for liquidity reasons or to decrease their concentration risk. However, it’s best to proceed with caution in this situation.
The most prudent approach is to wait until there is enough public information available to make a more informed decision. IPOs do include a prospectus, which provides valuable financial details, the company’s anticipated risks and opportunities, and information about how the money raised will be used. While this information is helpful, it’s a pretty skinny body of research compared to the material available on established public companies. However, that body of research will grow quickly as more analysts begin to follow the new company and it makes mandatory SEC filings.
Wait for the details to emerge. A quality company most likely has decades of growth ahead—and the trajectory will not be straight up—so there will be many opportunities to invest.
Our Take: Don’t Lose Sight of Your Long-Term Goals
The idea of making a fortune with a one-time investment in an IPO sounds exciting, but investing is a long-term game. Focusing on investing in a diversified portfolio filled with quality companies is the more prudent path for most investors. Investing in untested companies is simply an unnecessary risk—at least Warren Buffett thinks so. But if you do decide to dabble, make sure you understand the risk, and keep it to a very small portion of your portfolio.