Investing

Thinking of investing in a new IPO like Airbnb or DoorDash? Tread carefully, experts say

"For every 100 IPOs you invest in, 60 are likely to underperform significantly."

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Investing in hot new companies has rarely been this, well, hot. After slowing to a virtual standstill in the spring amid Covid-19-fueled uncertainty, the market for initial public offerings (the process by which companies make shares available to the public) has sped up considerably since June amid a massive rebound in the stock market.

Investors have been piling in: So far this year, newly public stocks have bounced by an average of 36% from the offering price on their first day of trading, according to data from Jay Ritter, a finance professor and IPO expert at the University of Florida. That's considerably higher than the long-term average of 15% and the highest average annual return since the tech bubble years of 1999 and 2000.

And with well-known firms such as home-rental platform Airbnb and food delivery service DoorDash expected to go public imminently, and other well-known companies such as grocery delivery service Instacart and mobile brokerage Robinhood thought to be eyeing IPOs in 2021, you may be tempted to get in on the action.

Here's what you need to know.

Most IPOs 'underperform significantly'

Diving in on the first day of an IPO is a risky proposition, says Ritter. For one thing, the big first-day pops in the stock price you're likely to see in financial headlines are calculated from the pre-IPO "offering price" — the often artificially low price set by the financial institution that brings the IPO to market.

You're unlikely to get your hands on offering-priced shares, which are typically reserved for institutional investors, high-net-worth brokerage clients, and company employees. That means you'll have to buy shares after they've hit the open market, when there is no predicting which way the stock will move.

"Even if you get the offering price, for every 100 IPOs you invest in, 60 are likely to underperform significantly," says Josef Schuster, founder of IPOX Schuster, an investment research firm specializing in IPOs.

More than 60% of the over 70,000 IPOs from 1975 posted negative returns following their first day of trading according to a recent UBS analysis of data provided by Ritter. You needn't look back very far to see how shaky recently public shares can be following their exuberant first trading day. Shares in Lyft popped nearly 9% on the day of the ride-sharing firm's ballyhooed IPO. The shares sank by 12% the following day, drawing them below the offering price.

Investors should take a diversified approach to building stock portfolios and assign especially conservative weightings to recent IPOs, given their heightened volatility compared with stock of more seasoned firms, Schuster says.

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Before you decide to invest, vet firms carefully

If you're considering taking a small bet on your favorite soon-to-be-public firm, first examine the financial data in the company's S-1 filing with the Securities and Exchange commission. Companies with annual sales of more than $1 billion tend to outperform the broad stock market over the three years following their IPO, while those with less than $1 billion in sales tend to lag, says Ritter.

Beyond the numbers, search for firms with a large and growing market for their goods and services and that aren't threatened by intrusion from rival firms, he says.

It may also pay to take a wait-and-see approach. Shares typically dip after 90 days when the so-called "lock-up period" expires, allowing pre-IPO investors to sell their shares — and that's generally a good time to buy, says Ritter.

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Waiting also gives you a chance to examine a company's reported earnings and other financials, which is essential for understanding a stock's potential trajectory, says Schuster. "IPO prices are not driven by fundamentals, but that's exactly what will drive performance over the long term," he says.

Ignoring market headlines and focusing on fundamental measures such as earnings, profit margins, and cash flows can give you better insight into a potential investment.

And remember, though investing in any individual company — especially a brand new one — can be thrilling, don't let the excitement distract you from your core strategy, which, experts say, should feature a broadly diversified portfolio of low-cost, long-term investments.

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