IPOs Are Hot — But Should You Invest in Them?

Initial public offerings, or IPOs, seem to be all the rage among investors so far this year. In the last few months, Lyft, Pinterest, Uber, and Zoom all debuted on the public market by offering shares of stock for sale to public investors. Expedia and Airbnb are also expected to go public in the near future.

Around 100 companies go public each year, and the financial press gives a lot of attention to high-profile IPOs like these. This raises the question: Should you be jumping on the IPO bandwagon?

Suitable Long-Term Investments?

Before answering this question, the first thing to point out is that most average investors — even middle-class millionaires — don’t have enough money to participate in high-profile IPOs in a meaningful way. Even if you could get in on the early stages of a hot IPO, this might not be the best strategy to meet your long-term investing goals.

The fact is, while IPOs often open with a bang, this strong early performance often isn’t sustained over the long term. Take Snap, for example. The social networking company’s shares have fallen 31 percent since its much-anticipated IPO in 2017.

In an article published in Barron’s, the author cites research indicating that IPOs may not be suitable investments after a firm has gone public and shares are trading in the open market. This is due to the trading restrictions executives and owners face during the six months to one year after the IPO.

Once the lock-up expires, the share price often declines in value as insiders are free to sell their shares. In fact, IPOs have historically underperformed for up to two and one-half years after going public, the author states.

Corporate Buybacks: An Alternate Strategy

For many investors, it’s smarter to look at companies that are buying back their stock as potential investment opportunities than it is to invest in companies that are selling stock via an IPO. To understand why, we need to take a closer look at exactly why companies initiate IPOs and corporate buy-backs.

Private companies sell stock to the public via an IPO in order to raise cash to support continued growth. Many companies initiating IPOs, including the ones listed above, are not yet profitable — and their horizon for profitability may be a long way off.

Investors buying shares in an IPO are buying them on the expectation that the company will grow rapidly and be highly profitable one day. However, there’s no guarantee that profitability will ever arrive.

Amazon, for example, didn’t start turning a consistent profit until 2016, more than two decades after the company went public. Of course, Amazon is a wildly successful business and has rewarded long-term shareholders handsomely — but this is the exception, not the rule.

Also, since the goal of an IPO is to raise as much cash for the company as possible, the stock valuations of IPO businesses are often extremely high. Lyft is a good example of a recent IPO with high valuations that so far has failed to get off the ground.

The Lyft IPO launched at $72 per share in late March but plunged 12 percent on the second day of trading. The share price has continued to drop, falling below $60 — or 19 percent from the IPO price — in mid-April.

The Opposite of IPOs

Public companies initiated $1 trillion of stock buybacks in 2018. They are essentially doing the exact opposite thing as private companies executing IPOs. Instead of selling shares of stock to the public in order to raise capital, they are using their excess cash to buy back their own shares of stock from the public on the open market.

Here’s another way to look at it: Companies executing IPOs are in need of more cash to support continued growth in hopes of one day becoming profitable. On the other hand, companies initiating corporate buybacks are already profitable, and they’re utilizing their healthy cash flow to buy their own stock in a show of corporate strength.

So which type of company looks like the safest bet: the one that needs to raise more capital so it can grow and reach profitability some day … hopefully? Or the one that is profitable right now and can demonstrate this profitability by purchasing its own stock?

While some legislators have criticized corporate buybacks as being damaging to the economy, two corporate heavyweights have voiced their support. Berkshire Hathaway CEO Warren Buffett and JP Morgan Chase CEO Jamie Dimon recently said that corporate buybacks are valuable to investors and the economy.

Take a Deep Breath

Of course, not every company initiating corporate buybacks proves to be a successful long-term investment. And not every IPO fails to produce returns for investors. In fact, several fairly recent IPOs have resulted in extraordinary investor returns, including MasterCard, Alibaba and Facebook.

But in the current environment where the latest hot IPOs get breathless attention and coverage from the financial press, it’s useful to pause and think carefully about whether investing in an IPO is the right strategy for you. We encourage you to discuss the pros and cons of IPO investing and investing in companies initiating corporate buybacks with your financial advisor.