Initial public offerings (IPO) are perceived as inherently good investment opportunities because these provide the investor the chance to buy the stock at the “ground floor.” which are likely to be profitable.
But the truth is not all IPOs are winners. Sure, there have been IPOs in the past that have doubled or tripled shortly after listing but there are also many newly listed stocks that went downhill right from the start.
The first time that the stock of a private company is sold to the public, got a little crazy in the days of dotcom mania of the 1990s. Back then, investors could throw money into just about any IPO and be almost guaranteed killer returns—at first. People who had the foresight to get in and out of these companies made investing look easy. Unfortunately, many newly public companies like VA Linux and theglobe.com experienced huge first-day gains but ended up disappointing investors in the long run.
Do Your home Work!!!
An oversubscribed IPO doesn’t always mean the stock will do well. In the same way, low demand for an IPO doesn’t mean the stock will be a loser. Investing in IPOs can be riskier than buying a stock with long trading history.
The lack of track record in the stock market makes an IPO unpredictable in many ways. There are unknown risks that come with newly listed stocks, which raise the returns that investors expect from IPOs.
Because of this, underwriters and issuers price their IPOs based on investors’ demand to make sure the final offer price is aligned with market expectations
There are two kinds of investors in the market, the informed and the uninformed. When the market is strong and risk appetite is high, IPOs tend to be overpriced because uninformed investors dominate the allocation of the share offer, who end up losing later on.
But when market confidence is low and uncertainties abound, IPOs tend to be underpriced. Informed investors, who take up most of the allocation during this period, get discounts for taking additional risks. The higher the uncertainties, the greater is the discount.
While underpricing an IPO may have strategic benefits of creating demand, it has its own limitations. The degree of underpricing and its impact on IPO vary due to several factors.
One reason can be the portion of shares offered to the public. A company planning to do follow-on offering in the future may offer a small portion of its shares initially at huge discount in order to create positive market sentiment toward the stock.
Be Cautious And be Profitable
Skepticism is a positive attribute to cultivate in the IPO market. As we mentioned earlier, there is always a lot of uncertainty surrounding IPOs, mainly because of the lack of available information. Therefore, you should always approach an IPO with caution.
If your broker recommends an IPO, you should exercise increased caution. This is a clear indication that most institutions and money managers have graciously passed on the underwriter’s attempts to sell the stock to them. In this situation, individual investors are likely getting the bottom feed, the leftovers that the “big money” didn’t want. If your broker is strongly pitching a certain offering, there is probably a reason behind the high number of these available shares.
This brings up an important point: Even if you find a company going public that you deem to be a worthwhile investment, it’s possible you won’t be able to get shares. Brokers have a habit of saving their IPO allocations for favored clients; unless you are a high roller, chances are good that you won’t be able to get in
This Year Hasn’t Be Kind To Unicorns
From fitness-bike sellers to ride-hailing giants, 2019’s newly public companies are floundering despite their quick rises to cultural prominence. Nearly half of all companies to go public in 2019 are trading below their offer prices, with major IPOs wiping out hundreds of millions of dollars in investor wealth in a single day.
Perhaps the most high-profile example is the ride-hailing duopoly of Uber and Lyft, which stumbled out of the gate and have struggled to regain their footing. There’s also Peloton, which opened 6.9% below its offer price, marking the third-worst trading debut for a mega-IPO since the financial crisis.
Some unicorns haven’t even made it to market at all. They’ve either cancelled their IPOs entirely, or delayed them significantly. WeWork announced Monday it’s indefinitely postponing its public offering as its new co-CEOs “focus on our core business.” The announcement sent WeWork bonds to record lows.
For context, a startup achieves “unicorn” status after receiving a $1 billion valuation. Those types of companies are quick to garner investor interest from their novel status among traders and analysts, yet the latest batch is faring far worse than past startup classes.
Unpacked below are three reasons why investors are fleeing the once-popular unicorn investments and bringing new scrutiny to those companies. There’s also a look ahead at the potential implications.
This year’s IPO class is the least profitable since the tech bubble, with less than a quarter of the newly tradable companies set to reach positive net income by 2020. Many of this year’s unicorns – and their disruptive “platform” models – are struggling to reach levels of profitability sought by public investors, and its sending their stock prices to the floor.
The growing focus on software-based businesses has led many firms to classify themselves as software companies, but “that narrative is now falling apart” as investors demand software-company margins, venture capitalist Fred Wilson wrote in a Sunday blog post.
Some software unicorns have maintained their IPO prices through the year, with Cloudflare and Zoom Video both trading above their offer level. Wilson notes that the two companies have gross margins of 81% and 77%, respectively, above the 75% standard for software companies.
On the other hand, some of the year’s biggest IPO flops tout themselves as software companies but lack the margins to match. Here’s where those public-market duds last reported gross margins:
- Uber: 46%
- Lyft: 39%
- Peloton: 42%
- WeWork: roughly 20% (S-1 filing used a slightly different metric)
“If the product is something else and cannot produce software gross margins then it needs to be valued like other similar businesses with similar margins, but maybe at some premium to recognize the leverage it can get through software,” Wilson wrote.
The Macro Landscape
Though recession fears have calmed from their late-August highs, plenty of factors continue to drive market volatility and keep investors on their toes. A recent Preqin survey covering the second half of 2019 found 74% of investors viewing the market at the peak of its cycle, implying a downtrend is just around the corner.
Meanwhile, major stock indexes have remained near record highs despite significant outflows from equity markets, with investors moving capital to less volatile investments.
The latest warning signs hint at an upcoming economic slowdown, and it may be scaring investors away from volatile IPOs. Stocks are among the riskiest assets to hold in a downturn, and newly public companies typically see more price swings than average as investors pile in to make their first bets.
While margins and marketing are crucial for investors looking to back a unicorn, macroeconomic conditions could keep investment away from equities as a whole.
The move from private to public ownership has become increasingly rocky, as investors are expecting more from unicorns and aren’t as easily swayed by lofty marketing techniques.
WeWork’s IPO filing noted its goal was to “to elevate the world’s consciousness.”
Peloton “sells happiness” according to its S-1 filing, before adding, “but of course, we do so much more.”
Lyft “is at the forefront of a massive societal change.”
IPO documents tend to lean toward the dramatic and appeal to investors with ambitious language. However, many of the unicorns pitching themselves as disruptive to the status quo don’t possess the business models to reliably grow profits.
“When it comes to ‘platform’ companies, venture capital has done a generally terrible job building these businesses into viable companies,” DataTrek researcher Nicholas Colas wrote in a September 27 note.
Public investors’ need vibrant, growing platform companies to create long-term value,” he added, and “the focus on price momentum over fundamentals” that worked in private funding doesn’t attract public capital as easily.
Dip Deep For Objective Research
Getting information on companies set to go public is tough. Unlike most publicly traded companies, private companies do not usually have swarms of analysts covering them, attempting to uncover possible cracks in their corporate armor. Remember that although most companies try to fully disclose all information in their prospectus, it is still written by them and not by an unbiased third party.
Search online for information on the company and its competitors, financing, past press releases, as well as overall industry health. Even though good intel may be scarce, learning as much as you can about the company is a crucial step in making a wise investment. On the other hand, your research may lead to the discovery that a company’s prospects are being overblown and that not acting on the investment opportunity is the best idea.
Pick A Company With Strong Brokers
Try to select a company that has a strong underwriter. We’re not saying that the big investment banks never bring duds public, but in general, quality brokerages bring quality companies public. Exercise more caution when selecting smaller brokerages because they may be willing to underwrite any company. For example, based on its reputation, Goldman Sachs (GS) can afford to be a lot pickier about the companies it underwrites than John Q’s Investment House (a fictional underwriter) can.
However, one positive of boutique brokers is that, because of their smaller client base, they make it easier for the individual investor to purchase pre-IPO shares (although this may also raise a red flag, mentioned below). Be aware that most large brokerage firms will not allow your first investment to be an IPO. The only individual investors who get in on IPOs are long-standing, established, and often high-net-worth, customers.
Always Read The Prospectus For Profitable
We’ve mentioned not to put all your faith in a prospectus, but you should never skip perusing it. It may be a dry read, but the prospectus lays out the company’s risks and opportunities, along with the proposed uses for the money raised by the IPO.
For example, if the money is going to repay loans or buy the equity from founders or private investors, look out! It is a bad sign if the company cannot afford to repay its loans without issuing stock. Money that is going toward research, marketing, or expanding into new markets paints a better picture.
Most companies have learned that over-promising and under-delivering are mistakes often made by those vying for marketplace success. Therefore, one of the biggest things to be on the lookout for while reading a prospectus is an overly optimistic future earnings outlook; this means reading the projected accounting figures carefully.
You can always request the prospectus from the broker bringing the company public.
Saudi Aramco IPO: World’s most profitable company to go public
Saudi Aramco has confirmed it is planning to list on the Riyadh stock exchange, in what could be the world’s biggest initial public offering (IPO).
The state-owned oil giant will determine the IPO launch price after registering interest from investors.
Business sources say the Saudis are expected to make shares available for 1% or 2% of the firm, and the offer will be for existing company shares.
Saudi Aramco is thought to be worth about $1.2tn (£927bn)