Should You Invest in an IPO?

Are Initial Public Offerings Appropriate for Regular Investors?

Invest in an IPO
The idea of investing in an IPO excites a lot of investors. Is it right for you or should you stick to more traditional blue chip stocks?. Ken Brown / E+ / Getty Images

One of the first questions new investors seem to want to ask is whether or not they should be looking at investing in initial public offerings, or IPOs, for their portfolio.  An IPO, in case you haven't learned about the specifics, yet, occurs when a formerly private business decides to take on outside investors, either by having the founders sell some of their shares or by issuing new shares to raise money for expansion, while, at the same time, listing those shares on a stock exchange or an over-the-counter market.

 

I suppose the appeal of IPOs is understandable.  Not only are you supplying capital to the economy -- capital that can grow real businesses that provide real goods and services to consumers -- but you get to enjoy the dream of repeating the experience early investors in firms such as Wal-Mart, Home Depot, Walt Disney, Dell, Tiffany & Company, Microsoft, NIKE, Coca-Cola, Target, or Starbucks. A single purchase in your brokerage account, a block of common stock delivered, and decades later your family is obscenely wealthy.  You find a wonderful business that is destined for tremendous growth and hold on for dear life as you go along for the ride.

In the case of many of these highly successful IPOs, the annual dividend income alone exceeded the original investment amount within a quarter of a century.  On top of this, the aggregate cash dividends received had paid back the initial outlay many, many, times over.

 The shares truly became money machines, printing ever-increasing sums of cash for their owners that they could then go use however they wanted.  The biggest downside for the IPO investors was dealing with volatile price fluctuations along the way.  It is not an exaggeration to say that there were many periods, sometimes lasting for extended lengths of time, during which the shares would fall in quoted market by 30% to 50% or more.

 Of course, to the true investor, this didn't matter as long as the look-through earnings kept getting bigger and the dividend growth record kept on smashing new records.  Sadly, when you look at actual invest behavior, a lot of stockholders don't behave this way.  Rather than valuing the business and buying accordingly, they look to the market to inform them.  They don't understand the difference between intrinsic value and price.

Consider The Coca-Cola Company.  A single share of Coke purchased for $40 in the IPO back in 1919 would have grown to more than $5,000,000 with dividends reinvested by the time this article was originally published on July 31st, 2006.  Now that I've come back to update it on December 31st, 2014, the figure stands at more than $15,000,000.  The Coke IPO changed lives forever.  (One small town, Quincy, Florida, became the per capita millionaire record holder in the United States because the local banker convinced everyone the company was one of the greatest businesses in operation.  The banker realized that not only were the financial statements strong, but that the product was largely insulated from economic stress such as recessions and depressions because even if you lost your house, your job, and were waiting in a breadline, if you came across a nickel, you might spend it on a glass of Coca-Cola; an affordable luxury that provided momentary pleasure.

 The brand power was and is, extraordinary.) Here's the kicker: The IPO investor would have watched his $40 share fall to $19 within the first year of owning it! How many people gave up on the already-dominant beverage giant in the world because of other investors making a mistake in pricing.

Wal-Mart Stores, Inc. is a similar story.  Go back to the original IPO in the 1960's when Sam Walton was rolling his stores out across the country and a $10,000 investment with dividends reinvested is now worth somewhere between $15,000,000 and $20,000,000.  He turned truck drivers, cashiers, store managers, executives, and early investors into multi-millionaires.

But not all initial public offerings work out in the end. What if you had purchased companies such as WebVan, the bankrupt web grocer from the dot-com era that left investors with catastrophic losses?

 The people who used their savings to acquire ownership watched their portfolio's precious capital draining away; capital that could have compounded into a huge nest egg if given enough time. It came down to one simple reality: Unlike other companies that sponsored IPOs, WebVan couldn't make any money. The early investors were destroyed by valuation risk. At some point, the company behind the IPO must begin making real profits they can distribute to owners.

With all of this being said, we're still left with the question: Should you consider investing in IPOs?

The Classical Value-Investing View of IPO Investing 

Benjamin Graham, the father of value investing and much of modern security analysis, recommended in his treatise The Intelligent Investor, investors steer clear of all initial public offerings. The reason? During an IPO, the previous owners are attempting to raise capital for expanding the business, cash out their interest for estate planning, or any other myriad of reasons that all result in one thing: a premium price that offers little chance for buying your stake at a discount. Often, he argued, some hiccup in the business will cause the stock price to collapse within a few years, giving the value minded investor an opportunity to load up on the company he or she admires. As even our Coca-Cola example proved, this often turns out to be the case.

While I generally consider this advice to be wise, especially for inexperienced investors who should probably opt for something like an index fundworking with a qualified advisor or, if they are wealthy enough, an asset management group, the problem comes from the fact that if you find a truly outstanding business – one that you have conviction will continue to compound for decades at rates many times that of the general market, even a high price can be a bargain. Indeed, looking back a decade ago, Dell Computer was an absolute steal at a price to earnings ratio of 50x! It was, in fact, the ultimate value stock because the discounted present value of the actual, real future cash earnings was far greater than the stock price at the time. Given the difficulty of sorting out the chaff from the wheat, you are probably going to do better by sticking to your guns. In theory, Graham’s position is one of conservative, disciplined safety. It ensures you won’t get burned and the average investor will likely be well served in the long-run by adhering to that principle.

Questions to Ask Yourself Before Investing in an IPO

Still, you may decide the risks of IPO investing are worth it.  A lot of smart people have.  Billionaire investor Charlie Munger, who has summed up his approach to investing in a beautifully simple way, has said that were he a young man these days, he very well might take a dedicated portion of his portfolio and focus on finding a handful of promising ideas each decade in which he was willing to swing for the fences, judiciously selecting only the best of the best where he thinks the numbers make sense.  It may not be a bad strategy for someone who already has their core portfolio in place, enjoys large amounts of disposable income, has the ability to analyze income statements and balance sheets, and enjoys some degree of speculation.  

At times, it can even serve the public good in much the same way investing in municipal bonds can help society. Think about the fiber-optic cable laid during the dot-com boom, funded by investors willing to drive the share prices to the moon. Overcapacity eventually resulted in billions upon billions of dollars in write-downs and more than a few bankruptcies. Many of those investors lost the money they risked. However, it laid the groundwork for the long-term ascension of businesses such as YouTube, Netflix, Amazon, Google, and more. All of us enjoy the dividends from their irrational exuberance.

That said if you insist upon risking your capital and investing in an initial public offering, ask yourself a few key questions:

  • If this business does not grow at a high enough rate to justify its price, what is the likely cause? What are the probabilities of those failures occurring?
  • What are the competitive moats that protect the business? Patents? Trademarks? Key Executives?  What is stopping some other firm from coming in and destroying the attractive economics?
  • Would you be comfortable owning this business if the stock market were to close for the next five, ten, or twenty-five years? In other words, is this business model and the company's financial foundation sustainable or is obsolescence as a result of technological advancement or lack of sufficient capital a possibility?
  • If the stock falls by fifty percent due to short-term problems in the business, will you be able to continue holding without any emotional response if you can conservatively determine that the long-term potential of the business still remains promising?

Finally, realize that the odds are stacked against you. IPOs, as a class, do not perform very well relative to the market. They're already priced to perfection in many cases. This is not an area where you can do well by spreading your beats across the board and buying everything in equal weightings. Rather, it's more along the lines of a specialty operation -- you need to be like a sniper. Figure out what it is you are looking for, then wait patiently, perhaps even for years, before it appears on the horizon. You can't force a good deal to happen. Opportunities often arrive in clusters, are ephemeral, and dissipate before you realize it and you must be prepared.