Good morning and happy Monday! Let’s get to it.
2021 has been a record breaking year for a multitude of things, but something seeming to be unnoticed is the amount of initial public offerings. Earlier this year, I wrote about Initial Public Offering’s, or IPOs, and other ways that companies can access the public markets.
Since then, the total number of IPOs for 2021 has climbed to 717, smashing last years record-breaking 480. For perspective, the height of the dot-com bubble in 2000 saw 397 IPOs.
Financial press often likes to look towards the IPO market as one of the indicators for stock market bubbles. If the number of IPOs, or the valuations for those offerings creeps into record breaking territory, it is time to sound the alarms.
Today, I want to take a closer look at the IPO “pop”, which is the first day returns of a stock that listed via an IPO.
Before I go further, I want to quickly point out the impact SPAC IPOs have on these numbers. A quick look at this chart will show that a lot of these IPOs for 2020 and 2021 are a factor of an exponential increase in the amount of SPAC IPOs.
While this is important, many of the newly listed SPACs are still looking to merge with a firm. This means that while there may be an impact on the “pop” returns due to the hype behind a SPAC going public, the long term returns are impacted less.
Some numbers
As I had brought up before, there were a comparable amount of IPOs during the dot-com bubble of 2000. During this time, those newly listed stocks saw a 60% increase on the first day of trading.
Data from Jay Ritter says that the average IPO pop from 1980 through 2020 was 18.4%.
Why the pop happens
When a company goes public, there is (yet again) a trilemma of interests for the parties involved in the deal.
Banker
The banker is somewhat of the intermediary for an IPO. When a company wants to go public, the bank will go out to prospective investors and try to gauge the market’s interest in the company. Because of this, the banker has a long term relationship with the company, and wants to maintain that. They also have an obligation to fill the order they took on, and provide the company with the ability to raise as much money that the markets will provide.
Company
The company has a conflict of interest with itself on top of the other parties. It wants to raise as much money as possible while minimizing share dilution, yet also be mindful about the long term share price/market cap potential of the company.
Institutional Investor
The investor solely wants to earn as high of a return as possible. This becomes easier when the IPO price is lower than the market would be willing to pay.
You can see why there is a conflict of interest here, and it is in the bank’s hands to make sure that the institutional investor and the company are both satisfied.
2021 Stats
The chart below shows the return data for IPOs in 2021 from StockAnalysis. You can see that a significant amount of IPOs took place in the first three months of the year, and that a lot of the returns for those companies have pulled back to the median return of -2.43% (the mean return is 5%).
Keep in mind this is YTD return, not the IPO “pop” return
The percentage change of the more recent filings have had a pretty great run too, beating the NASDAQ by 26.4%:
External factors
Looking a little further into the environment in which IPOs take place, there are absolutely contributing factors beyond the company itself.
Goldman Sachs says that these four factors weigh heavily into the price action for recent IPOs.
Sector and Industry - the dot-com boom obviously saw tech and media companies leading the way, whereas a decade later in 2010, health care had nearly double the amount of new listings.
Valuation - Trends in IPO valuations are what can lead analysts to believe there is a correction coming. During the dot-com bubble, new listings were well beyond the median S&P 500 company valuation.
Path to profitability - We’ve been seeing this one for a while, but new tech companies are years beyond becoming profitable. The reason they still attract so much funding and attention is because some of the largest firms in the world today started off unprofitable.
Sales growth - Younger companies often see more sales growth shortly after listing as opposed to older companies. Since 2010, companies with higher sales growth are more likely to outperform the Russell 3000 compared to slower growing firms.1
Size and IPO price - This chart from Nasdaq shows that company size has also had impact in the first day returns. Furthermore, when a company IPOs they list a filing range prior to the IPO, telling where they expect the share price to be on the first day of trading.
This chart shows the pop for a company’s list price relative to their file range.
Herding sheep
Beyond the list above, one of the main factors that investors should be aware of is the impact of media. The 2020-2021 bull market has been something never seen before, both in the time of recovery from recent lows and all time highs becoming the norm. There is a lot of noise that has taken place over the course of this run, for better or for worse.
The WSB subreddit has led to explosions in price completely separated from fundamentals, and other forms of mob mentality have pumped up meme stock’s market cap. This influence on the markets is completely foreign and it is unknown what impact it will have in the future.
So what?
This is not to say that chasing IPOs to try to make a quick buck is an effective strategy. Looking back, there is some consistency in the first day returns seen over the course of an IPO bull market. But like everything, it can change in an instant.
Being mindful of market conditions as well as company fundamentals and history is a sound way to understand what you are getting into when investing into IPOs.
Thank you for reading! Have a great week as always.
https://markets.businessinsider.com/news/stocks/5-most-important-factors-for-successful-ipo-performance-goldman-sachs-2019-9
A useful sheet for looking at current SPAC landscape - https://www.spacanalytics.com/
https://site.warrington.ufl.edu/ritter/ipo-data/
https://marker.medium.com/why-the-day-one-ipo-pop-is-overhyped-85fbab29103b
https://www.nasdaq.com/articles/trends-in-ipo-pops-2021-03-04
Really interesting perspective. The initial pop of 18.4% is certainly attractive. I wonder if this could also be a long-term strategy for buy and hold investors?