IPOs involve a great deal of uncertainty, which makes them risky. Thus, investors expect higher returns as compensation for the higher risk. However, there is a large body of evidence that demonstrates that, unless you are sufficiently well-connected (to a broker-dealer who is part of the issuing syndicate) to receive an allocation at the IPO price, IPOs have underperformed the overall market.
Daniel Hoechle, Larissa Karthaus and Markus Schmid contribute to the literature on IPO performance with their March 2017 paper, “The Long-Term Performance of IPOs, Revisited.” Their original data set consisted of U.S. companies going public between January 1975 and December 2014.
After applying several screens (such as depositories, real estate investment trusts, closed-end funds, partnerships and low-priced stocks), the final sample consisted of 7,487 IPOs. While prior studies looked at the returns of IPOs in the first few years, Hoechle, Karthaus and Schmid analyzed IPO performance over varying time horizons, ranging from one to 40 quarters.
Following is a summary of their findings:
- IPOs tend to be high-beta stocks and have negative exposure to the value factor.
- The Carhart four-factor (beta, size, value and momentum) model explains IPO underperformance over three- to five-year post-issue periods.
- IPO firms continue to underperform over the first two years after going public—even when differences in size, book-to-market and momentum are accounted for.
- Underperformance peaks at a risk-adjusted -2.4% per quarter exactly one year after going public—translating to underperformance in the first year in excess of 10%.
- Underperformance gradually declines, becoming insignificant beyond two years after going public.
- The findings were robust to different asset pricing models (specifically, the Fama-French three-factor and their newer five-factor model, which includes profitability and investment).
- IPO underperformance substantially decreased after the internet bubble burst in 2000. While IPO underperformance stayed economically meaningful at 1.5% per quarter and statistically significant at the 1% level, even for five-year post-IPO periods between 1975 and 2000, there was no evidence of significant IPO underperformance beyond one year after going public post 2000.
The authors reported other interesting findings:
1. Underperformance was concentrated in small-stock IPOs. Small-firm IPOs underperform small, mature firms over the first year after going public by a risk-adjusted 3.4 percentage points per quarter and was significantly different from zero at the 1% level. In contrast, there was no significant underperformance of large-firm IPOs compared to large mature companies, even in the first year after going public.
2. IPOs tend to be high-beta stocks. While not surprising, it’s important. The reason is that high-beta stocks have underperformed low-beta stocks, one of the most prominent anomalies in finance and a violation of the capital asset pricing model.
3. A significant underperformance was associated with nonventure-backed IPOs for the first year after going public, but no significant difference was found in the performance of venture-backed IPO firms and mature companies. In fact, nonventure-backed IPO firms significantly underperformed mature companies up to five years after going public.
4. A large body of literature documents an underpricing of IPOs—a positive return from the offer price to the closing price of the first trading day. The authors found that IPO firms with both high and low underpricing significantly underperform mature firms over the first year after going public. However, they found IPO underperformance to persist for up to five years post-issue for low underpricing firms (the largest underperformance occurring in the first year), but for only the first year post-issue for high underpricing firms.
5. The underperformance existed whether or not the IPO occurred in a period of “hot” issuance.
Hoechle, Karthaus and Schmid concluded there’s a “statistically significant and economically meaningful underperformance of IPO firms over time horizons of up to two years even when the usual risk factors are accounted for.”
They found this to be the case even after controlling for the new factor of investment—low-investment firms outperformed high-investment firms. Also of interest, they found that firms underperform when they are aggressive in terms of acquisitions.
Clearly, IPO investors were not rewarded for taking risk. So what’s going on? The literature suggests two explanations. The first is the lottery effect.
The Lottery Effect
It’s well-documented that investors prefer “skewness” in returns—they’re willing to accept a high probability of a below-average return for the small chance of earning an outsized return (e.g., if they find the next Google). This is what’s often referred to as the “lottery effect.”
The second explanation is referred to as “the winner’s curse.”
The Winner’s Curse
Eric Falkenstein explains the winner’s curse in his book, “The Missing Risk Premium: Why Low Volatility Investing Works.” Let’s say you have to guess the number of jelly beans in a jar. If you compute the average of all the guesses of a large crowd, it’s usually very close to the actual number. While some of the individual guesses are off by a wide margin, the lowest guesses offset the highest guesses.
Now imagine this group in the context of an auction. The result of averaging the maximum prices everyone would pay for an item should be a very close approximation of the item’s true value.
However, that’s not the way an auction works. The person who wins the auction is the one with the highest bid, which is obviously higher than the average price (or approximate value of the item), meaning the person will almost certainly overpay.
With a stock, some investors will perceive its value as higher than the market price and others as lower. That balance is what gives a stock its price. However, IPO stocks may not have that same balance, for a few reasons:
- Not enough stock is available for pessimistic investors to short (and drive its price down).
- Institutional investors may have charters preventing them from shorting stocks.
- Shorting can be expensive.
- Investors may be too fearful of the unlimited loss potential associated with shorting.
As a result, the optimistic investors are the ones driving prices, causing the initial jumps associated with many new stocks. “The wisdom of crowds” applies to the average (mean) guesses of, say, the weight of an ox, or how many jelly beans are in a jar. It turns out that, while there are large errors, they tend to be randomly distributed (both high and low). If the average guess is truly the best estimate, the highest estimates are biased upward.
The term “the winner’s curse” was coined in the 1950s to describe the fact that, for auctions of oil fields, the winners were generally cursed by winning (if the average bid was closest to the best estimate of the correct value, the winning bid was too high). The same principle can apply to stocks, especially in cases where it’s difficult for arbitrageurs to drive the price back to its “true” value, as with IPOs.
The combination of the winner’s curse and the preference for skewness can explain not only the poor performance of IPOs but also the poor performance of small-cap growth stocks, penny stocks, stocks in bankruptcy, high-beta stocks and seasoned equity offerings.
The bottom line is that when it comes to IPOs, despite their higher risk, unless you’re well-connected enough to get an allocation at the IPO price (the average IPO tends to jump on the first day), the returns have been poor.
As Richard Feynman, one of our most famous theoretical physicists, said, “It doesn’t matter how beautiful your theory is, it doesn’t matter how smart you are. If it doesn’t agree with the experiment, it’s wrong.”
This commentary originally appeared May 3 on ETF.com
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