As a clan, value investors tend to be wary of the initial public offering (IPO). Not only are there sound behavioural finance reasons for this – as we explained, for example, in Fear of the new, IPOs are often richly priced and the sellers are inevitably better informed than the buyers – there is also significant academic evidence to suggest potential investors should think twice before parting with their cash.
A number of IPO-related studies – each showing first-day returns are usually positive but that it tends to be all downhill thereafter – are highlighted by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School in one of the articles they have written for the 2015 edition of the Credit Suisse Global Investment Returns Yearbook.
Thus, for example, in a 2014 study, Jay Ritter of the University of Florida analysed 7,793 IPOs that took place in the US from 1980 to 2012 and found investors who bought at the issue price made an average first day return of 17.9%. Over the next three years, however, investors then experienced an average market-adjusted loss of 18.6%.
It is a similar story in the UK. In a paper published earlier this year, Dimson and Marsh themselves analysed 3,507 IPOs from 2000 to 2014 and found that the market-value weighted average first-day return for investors who bought at the issue price was 8.5%. Over the next two years though, the average loss, adjusted for market movements, was 9.4%.
For its part, a 2010 study by Alan Gregory, Cherif Guermat and Fawaz Al Shawawreh showed that post-IPO underperformance lasts even longer. Their analysis of 2,499 IPOs that occurred in the UK over the period from 1975 to 2004 revealed an average underperformance of 31.6% over the five years that followed the IPOs.
While it is always nice to have one’s prejudices validated by statistics, however, what really caught our eye in the article was the following graph, which shows the impact on UK stock returns of something known as ‘seasoning’ – a term coined 40 years ago by Yale finance professor Roger Ibbotson to describe the amount of time that has elapsed since a company’s IPO.
Source: Credit Suisse Yearbook
The four lines show the returns over the last 35 years from a strategy of investing in stocks that, at the start of each year, had three years or less seasoning; four to seven years; eight to 20 years; and more than 20 years. Dimson, Marsh and Staunton rebalanced the four portfolios annually to ensure they always capture the appropriate range of seasoning.
What you may not be very surprised to see is that the greater the seasoning, the higher the returns. “At the stock level, old clearly beats new,” observe the three authors. “And since new industries are disproportionately represented among IPOs, this lends credence to the observation that new industries and new technology often experience periods of over-enthusiasm.”
Two obvious conclusions suggest themselves here. One is that, when there is too much enthusiasm for one kind of investment, there is often too little for another – and both of those are integral elements within value investing. The other is that, whether looked at through the lens of behavioural finance or after crunching the numbers, IPOs really are something best left to speculators rather than investors.