New stock issues generally come to market when it’s a good time for investors to sell. But it’s seldom a good time for investors to buy.
Human nature puts the odds against you when you invest in new stock issues (also known as IPOs or Initial Public Offerings).
Insiders decide when to bring new stock issues to market. They mostly do so only when it’s a good time for the company or its insiders to sell stock to the public. That means new issues tend to come to market when the company or its industry is enjoying what may be a temporary improvement in business or profit. If the improvement is only temporary, this generally isn’t a good time for you to buy.
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Financial institutions know how to package a new issue to make it seem like a great deal. This tends to raise the price that you pay for a new issue, compared to a stock that is already trading in the market. That’s a second reason why new issues tend to be overpriced in relation to a balanced assessment of their prospects. In addition, the underwriting process adds costs, for commissions (usually 5% to 7% of the funds raised), plus legal and accounting expenses.
New stock issues may simply become underperforming stocks
We hardly ever recommend buying new issues when they are first sold to the public. For that matter, we generally stay away from new issues for months, if not years, after they first come to market. As a group, new issues underperform the market over long periods. In addition, their results are far more variable than those of well-established stocks, and they expose you to greater risk of major loss.
Of course, many new issues do look like undervalued stocks and go up when they first hit the market. These are the “hot new issues” that everybody wants to buy. Unfortunately, hot new issues are always in short supply. Individual brokers get only a limited allotment, so they usually reserve them for their biggest and most profitable clients.
New stock issues tend to perform poorly over the long term
Long-term studies show that, on average, new issues tend to do worse than comparable stocks over a variety of time periods.
Professor Jay R. Ritter of the University of Florida updated his long-time study of more than 7,000 new issues that came on the market in the U.S. from 1980 through 2013. He studied returns on the new issues for the first five years after issue, in two ways.
The average yearly return over five years on the new issues was 3.1% below the return on existing stocks with the same market capitalization (or “market cap”, the value of all shares each company had outstanding). When Ritter matched the new issues with existing stocks that had comparable ratios of book value to market value, the new issue performance shortfall shrank to 2.0%.
Both comparisons in the study show that new issues actually beat existing issues in the first six months of trading. That’s when “hot new issues” have their biggest impact, and bring up the average new issue performance. However, hot new issues are generally unavailable to the average investor.
That’s why we rarely if ever recommend new issues when they first come out. We do make exceptions to this rule from time to time. In 2006, for instance, we advised buying Tim Hortons as a new issue. We felt the U.S. target audience for the stock would fail to understand the concept as well as Canadians. It seems we were right, and Tim’s was a great performer for us.
There is an element of chance in the success of every business, and it’s rarely worthwhile to test your luck by investing in new stock issues
One of the problems with a number of new issues is the excessive hype they receive from what we call the “broker/media limelight.” This causes expectations to be raised to often unrealistic heights—and the fall from those heights can be brutal.
As mentioned, most investors find that it’s hard if not impossible to get an allotment of a “hot new issue” that soars after it comes on the market. On the other hand, it’s all too easy to buy the new stock issues that plunge after coming on the market.
Do you see new stock issues as suspect investments because of their short time in the market, or do you believe new issues are great options for undervalued stock investing?
Investing in the wrong IPO can ruin your portfolio. Have you ever fallen prey to the allure of an IPO only to regret it later?
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