IPOs and Investment Time Frames

Early Effects of IPO Performance

There are certainly some IPOs that do very well over time, and this creates a lot of excitement among investors to want to be part of this action, which sees some stocks make huge gains over time from what it cost to buy the IPO initially.

Perhaps even more influential is the shorter term gains that some IPOs experience, although if we are investing long term that shouldn’t really matter too much to us, because this is not the time frame that we are investing in.

If an IPO goes way up in its first year for instance, that really has very little to do with where it may be in 10 years or 20 years, although this isn’t entirely meaningless because this at least bodes well for the future.

When an IPO doesn’t do that well in the shorter term, for instance with Facebook’s IPO, which is cited as a prime example of IPOs that didn’t do so well, this is not necessarily a cause for concern either.

Facebook shares were issued at $38, but when people started selling them a little while later, the stock lost half its value over the first three months of its life. Six years later though, it is trading at almost $200 a share.

In spite of its slow start, this stock has grown by over 500% in 6 years, which is a very nice return indeed for those who held the IPO or perhaps entered the market even lower, after the price dropped.

What we need to realize about these early periods is that there are a lot of things in play that will influence the trading price of an IPO, especially those who held the shares privately looking to cash in. This isn’t always a great move by the way, even if the share price is declining, and those who exited this stock at or below its IPO price and didn’t re-enter are surely sorry now, even though the appeal of a big payday after years of waiting is no doubt tempting.

It did take about a year and a half for this stock to finally surpass its IPO price and start moving in a positive direction relative to what it was sold for initially, but it did happen, although this isn’t always the case.

We never really know with any certainty whether an investment will pan out or not, and this uncertainty is the reason why taking on more risk does tend to come with at least potential rewards, but it is very important that we match our view of changes in the performance of an IPO or anything with the time frame we are using to invest.

How IPOs Do Long Term

In spite of all the hype that some IPOs get, IPOs are certainly riskier from a long term as well as a short term perspective. This doesn’t mean that a given IPO will underperform, as some do very well like Facebook has so far, and Facebook is still often referenced as what can happen when things go wrong, presumably because people aren’t looking at how this all has ended up so far.

IPOs and Investment Time FramesThis is a good example of not considering people’s investment time frames, and if you bought this IPO with the intention of only holding it for a very short period of time, of course you could have taken a beating here, and some certainly did.

If we are trading a stock though, we need to be aware that while IPOs can shoot up dramatically in the early stages, they can also fail to do so and even can go down quite a bit. We have to therefore account for this when we seek to manage our risk and keep our fingers on the trigger to get out sooner rather than later if things don’t go as well initially as we had hoped and we’re only looking for short term gains that don’t materialize.

Over the long term, in spite of the great success stories that we’ve seen over the years with IPOs and long-term performance, most IPOs don’t fare that well, and overall, they tend to underperform the market. There are reasons for this though, and this doesn’t mean that IPOs are not a good idea, but it does mean that we need to be selective in both the ones we invest in and how we manage these investments.

There are a lot of IPOs that hit the market that are not particularly significant, so called small cap IPOs, and these are the ones that tend to underperform more often than not. When advisors caution against people investing in IPOs, these are the statistics they are looking at, the overall performance of IPOs on average relative to the market.

A lot of people don’t fully appreciate what drives a stock price, and more than anything, stocks go up because there is more pressure to buy it than to sell it. While all stock transactions involve a buyer and a seller, the other side of these trades are often market makers, which are just there for short term profits, and the more interest there is from those who aren’t just looking to acquire and unload positions as soon as possible there is, the more the stock will go up or down on the side of this buying or selling pressure.

Long Term IPO Investing and the Market

What we want to look for, more than anything, is the appeal a certain IPO may have to investors, and in particular, to institutional investors such as funds. We also need to pay a lot of attention to the market in general, where if there is an influx of capital we may expect more buying pressure, with more selling pressure occurring during outflows when money is taken out of the market and invested elsewhere.

While market conditions may seem to pertain to short or mid term investing, this can and indeed is an issue with longer term investing as well, or at least should be ideally. We should never invest with our eyes closed completely to the stocks we hold and the market in general, even though many people do invest that way.

IPOs in particular have their performance correlated with market conditions, and underwriters pay a lot of attention to this, looking to introduce IPOs at times where market conditions are more favorable. If they are not, the IPO may be delayed, in spite of the eagerness of the company to look to cash in sooner rather than later.

IPOs do get introduced during bear markets, although there does tend to be fewer of them, and their performance is, not surprisingly, muted by this. If we’re asking people to invest in a company’s stock that just got placed on the market, it is of course a real benefit to do so at a time where people are looking to invest more generally, and not looking to reduce their exposure to the stock market.

Markets do have short, intermediate, and long term trends, and for instance during the Facebook IPO the market has been in a longer term trend up. If we had been in a bear market during the past 6 years, the tale here would very likely be a different one, and instead of seeing these huge gains, we would have seen something much less impressive and perhaps not very appealing at all.

When the market is going down though, we like to compare the performance of a stock to the market, and if one is looking to invest the money in other stocks, even a less than impressive IPO performance may still beat the market, and may do so handily. If the IPO has some real momentum relative to the market, people may pull out of it to a lesser degree than they are doing so generally with their stock holdings, and may even switch over to a better performing stock such as an IPO in the hopes that they may at least not suffer the same degree of loss.

Matching Trends With Investment Horizons with IPOs

As a general rule, it is unwise to be long something during market pullbacks, at least when the downward trend matches up with our investing horizons. If we’re investing long term, shorter term pullbacks in either our stocks or the market should not bother us too much, as we’re not investing in these shorter time frames.

If the downward trend is longer term though, then this is a different story, and we then need to ask ourselves whether it is wise to invest in something which at the present time does not have a positive outlook. Just because we might think that the stock may come back in 20 years or whatever time frame we’re looking at doesn’t mean that we need to ride it down over a significant period of time while we wait for this.

The magnitude of these moves also matters, and this is why more market savvy investors will use longer term performance metrics to help them guide the management of their positions. A good example of this would be the drop we saw in 2007-2009.

The stock market lost over half its value over a period of a year and a half, and whenever we are subject to such large moves in the value of our positions, looking to reduce these losses can be a good idea regardless of how long we expect to be investing.

Just because we want to manage our portfolios over several decades does not mean that we should necessarily want to stay in the same investments over this time, and this includes sticking with IPOs that end up disappointing us for whatever reason.

It doesn’t really matter why an IPO fails, if it does, whether it’s poor market conditions, the company not meeting expectations, people just not getting excited enough about it, especially institutional investors, or whatever else, if it is doing poorly, this is not why we got into it.

There are two main reasons why we may want to invest in an IPO, which are whether the IPO itself is a good choice, and it’s also whether the timing of getting into the IPO is right. If we get both of these right, we can indeed enjoy some very significant returns.

What we don’t want to do is lose sight of our investment time frame. If it’s a shorter one, and the IPO is disappointing shorter term, that’s a good reason to bail. If we’re in for the longer term, we’re going to need to see a lot more to want to exit, and what might get a trader out of the IPO like what happened with Facebook may not have us too concerned.

In particular, we need to be aware, if we are investing in an IPO longer term, that the dynamics of IPOs in their early stages are different, and the will to sell among those who hold big positions, to cash in on them, or even to wilt under pressure, is going to cause more short term volatility. We should be willing to give IPOs more room, not less, on account of this, and only exit when we truly see the longer term prospects fail to meet expectations.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

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