Why Investors Should Wait Before Buying a Hot IPO

Every year, new IPOs gin up tons of investors and consumer interest, and more often than not, people who bought when the IPO was hot end up getting burned.

It's "Never Will I Ever" week on Industry Focus, and on today's Tech episode, Motley Fool analysts Dylan Lewis and Michael Douglass explain why they'll never buy into an IPO until at least six months after it goes public. Listen in to find out why so many IPOs cool down after the first six months and some important things investors should look at before buying into any company. Also, the hosts explain why they'll never again invest in a grocery store.

A full transcript follows the video.

This video was recorded on July 14, 2017.

Dylan Lewis: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. It's Friday, July 14, and we're wrapping up "Never Will I Ever" week. I'm your host, Dylan Lewis, and I'm joined in the studio by my good friend and fool.com bureau chief, Michael Douglass. Michael, how's it going?

Michael Douglass: It's fantastic. It's Friday, everyone's looking forward to the weekend, and we're going to be having chicken for lunch.

Lewis: Chicken. Not just chicken, Bonchon.

Douglass: Bonchon.

Lewis: I know that folks who listened to the Memorial Day episode that we did for Industry Focus, they know how much we love Bonchon on the IF team and in editorial. Two of our interns, Connor and Addie, have never had Bonchon, the glorious double-fried Korean chicken wings.

Douglass: It's a crime.

Lewis: It's a crime.

Douglass: It's a scandal.

Lewis: So we're going to enlighten them today.

Douglass: Absolutely.

Lewis: I think that's how we can look at it. Today's also kind of a special occasion because we have a live studio audience.

Douglass: It's very exciting.

Lewis: We have John and Lisa, two listeners from Wisconsin. They're in town for a little bit, and they decided to stop by HQ and check it out, hang out for a taping. I think that's pretty cool.

Douglass: Yeah. It's really awesome whenever anyone decides to come visit HQ.

Lewis: Yeah. Listeners, if you're ever in the area, let us know, [email protected]. We love having people come by, check us out while we're doing tapings. We also love it when people give us ideas for shows. That's pretty nice, it makes our job a lot easier.

Douglass: Absolutely.

Lewis: Michael, we're wrapping up "Never Will I Ever" week. Tech is known for its high-flying IPOs --

Douglass: No.

Lewis: [laughs] Often, these tech companies, because they are so highly followed pre-IPO, when they're private, you have all these billionaire unicorns, there's a lot of fanfare, there's a lot of investor interest, there's a lot of consumer interest. A lot of times, these businesses are very consumer-facing. So when they actually do start going public, it's just craziness.

Douglass: I think it's not just that they're consumer-facing, but usually they're also claiming some sort of disruptiveness. When you're thinking about investing, people are excited about the idea of breaking an industry and creating something new, getting rid of newspapers and replacing them with the internet, or something like that. So this is that opportunity to do that with businesses that people can sort of vaguely understand and interface with.

Lewis: And I love covering IPOs, I do. I love doing those deep dives into company prospectuses, those S-1s, you know what I'm talking about.

Douglass: Oh, yeah.

Lewis: But my "Never Will I Ever" this week is, never will I ever buy a stock within six months of its IPO.

Douglass: And I think that's a brilliant call for a number of reasons. It's a rule that, when you said it to me before taping, I was like, oh, yeah, me too. So I'm on the Dylan Lewis train here.

Lewis: I appreciate that. That's why I had you on, because I knew I would get some supporting arguments.

Douglass: [laughs] A little groupthink here in Industry Focus on Friday, July 14.

Lewis: Yes, on Friday, July 14. At a glance, three companies that start to paint a picture about why I feel this way. You look at the big IPOs in tech from last year: Line Corp. down 17% since they went public. The S&P 500 is up 13% since then. Nutanix, down roughly 45% since about the fall of 2016, when it went public; S&P 500 is up 12% since then. Twilio, since IPOing in the summer of 2016, up 12%; the S&P 500 up 20%. So two of those three are down from where they first started trading, and all three are underperforming the market.

Douglass: Pretty substantially.

Lewis: Pretty substantially. I think there's just so much pent-up demand. You see shares soar with a lot of these IPOs so early on. People are just craving getting access to these companies because the hype is there that it winds up blowing up to these wildly unrealistic expectations.

Douglass: It's one of those interesting things. Warren Buffett talks about how you need to be greedy when others are fearful and fearful when others are greedy. When IPO season hits, when people are really talking about these IPOs, there are IPOs that, on their first day, triple. And people get crazy greedy, excited about this possibility. And I think they often leave all logic aside. That means there's just crazy stuff happening, particularly in those first few days, but also over this first six months, in a lot of ways. I think thoughtful investors need to be fearful and very careful about thinking about entering into these companies so early, particularly given the timing aspect.

Lewis: That is not to say that any of these companies are necessarily bad companies. I actually think Twilio is a very interesting business. I've been watching it on the sidelines. It's a company that I'm very interested in, have not bought shares of but am watching. But even if you look at a massively successful company, Facebook (META -0.52%), the stock was down 30% a year out from its IPO.

Douglass: Yeah, they had a pretty tough first year.

Lewis: They did. Part of that is huge expectations built into the company. So the core business metrics need to back up the valuation, and very often doesn't early on, just because you have to tumultuous nature of your first couple of reporting quarters and the scrutiny of being public. Also, Facebook specifically, there were all those concerns, remember, about the pivot to mobile, and whether or not Facebook was going to be able to pull it off.

Douglass: Hint: They did.

Lewis: Yeah, now it's, like, 80% of their traffic is mobile, and they're absolutely crushing it with mobile revenue and serving up stuff that people want. But that was a very legitimate concern for investors early on. So even in a success story there, even a year out, the market wasn't really sold on what was going on with Facebook. So my guidance for investors is, looking at tech IPOs and IPOs broadly, wait six months, I might even say a year. I think there are a couple of core reasons for this. The big one for me is, the company decides when it goes public. That's one of the most important things you have to understand about the IPO process.

Douglass: Yeah. In a lot of ways, they're timing the market for themselves. They're saying, "Here's the story we want to tell. The metrics are lining up with that story. Here's a great time to go public." And keep in mind, a company is very heavily incentivized to do this. The reason you go public, the reason you take on all the extra scrutiny and reporting, is so you can unlock a bunch of cash. So why wouldn't you do that when you can unlock the most cash, because you're able to tell the best possible story? It makes a lot of sense from a business standpoint. What that means, though, is that retail investors who are hopping in early may be coming in when things look better than, maybe, long-term, they could be.

Lewis: Yeah. IPOs are capital-raising events. That's the thing you have to remember. And management is deciding when they're going to be selling these shares. You might run into situations, I think Snap (SNAP -2.72%) might be an example of this, where at the time of filing, the business metrics maybe look as good as they're going to for quite some time. So with Snap and its property Snapchat, the company's user base was beginning to show signs of decelerating growth. I think they went from 20% sequential growth in Q2 of 2016 to 4% sequential growth in Q4 of 2016. So they might have been reading the tea leaves and saying, "I don't know that things are going to get too much stronger anytime soon. We haven't really turned on the ad monetization yet. We can sell a story of promise and potential. Let's raise capital now rather than risk the core business metrics deteriorating, and then raising capital at a lower valuation down the road."

Douglass: Absolutely. I think one of the other key things to look at is that you only have so much information to look at, going backward. The S-1, maybe they'll have a couple of years of data there. But you're not really able to tell a lot of the long-term story in a way that you can about, for example, Johnson & Johnson, which has been public forever.

Lewis: Yeah, and the filing requirements are actually different if you're an emerging growth company, which is less than $1 billion in revenue over the trailing 12 months or most recent fiscal year; I forget the exact categorization there. So how close to the IPO do you have to file, and some of the information you have to file, will depend. And that is meant to make it easier for smaller companies to go public. But that also can put investors at a little bit of a disadvantage. That is something to keep in mind. I think one of the things, particularly as Foolish investors, that we want to see with companies that buying into an IPO early doesn't give you access to is understanding how management handles the scrutiny of being public. I think that's such a big part of understanding the general philosophy of a business, and also, how they're going to weather tough times and not great business outcomes.

Douglass: We did an episode a little while ago about evaluating stocks, and we went through Facebook at that time. One of my key steps whenever I'm evaluating a company is to hear how management talks about it, because they are closer to the business than anyone else, and they will help paint a picture that the numbers themselves can't do. You can always say, "Revenue is this, and earnings are going like this." But management can really give you the color of "There were some puts and takes here; here's what happened in this past quarter and here's why we don't expect that to happen next quarter; here were some one-time tax charges; here's exactly what they were; here's why we think they were one-time." And if you don't have that kind of background and that kind of depth of knowledge and expertise, you're operating at a real disadvantage in terms of being able to really understand whether one company is better than another.

Lewis: And five months out from an IPO, you're only looking at one quarter of reports and one commentary.

Douglass: Yeah, maybe two, if you're lucky.

Lewis: Maybe. But odds are, you're not really getting too many interactions with management. And I also want to see that management says, "No, this is the long-term plan that we're sticking to." If that's a vision that you bought into as an investor, you want to make sure that's what they're going to do, that they're not going to course-correct just because they're hitting some short-term headwinds and decide that they're going to do something radically different with the business, because that's not what you bought into.

Douglass: Right. The measure of a management team is, I think, more what they do when they hit a snag than what they do when things are doing well. In the same way that the true measurement of an investor is what they do when their entire portfolio is down 15%, not when they've been sitting on multi-year gains like, let's say, in an eight-year bull market, for example.

Lewis: [laughs] For example, hypothetically.

Douglass: [laughs] Right, totally academic conversation here. But that's what really tells you whether this is a management you can trust, and whether it's a good management, is how they handle those snags, and those hurdles. You don't necessarily see that immediately. It takes time.

Lewis: Yeah. Again, bringing it back, this conversation isn't to say I wouldn't buy any of these stocks, or that it's something where I'm like, nine months out, absolutely not. It's just, you want to see several quarters of results; you want to have a better sense of what's going on. You just want as much information as you can possibly have, and maybe move beyond that hype cycle. That is my "Never Will I Ever." Michael, I know that you have a slightly different one also based on personal experience. Maybe a shared experience between both of us.

Douglass: [laughs] Yeah, kind of a shared experience. It's never will I ever buy a grocery-store stock again.

Lewis: Which is to say that you have bought a grocery stock at one point.

Douglass: Yeah. Didn't go so well.

Lewis: Me, too! 

Douglass: [laughs] Interestingly, we bought the same stock. We were actually talking about this particular stock when we were doing New Year's Resolutions Week way back in January. The stock was Whole Foods (WFM). I think we both had a thesis that made a lot of sense at the time about it, which was that you have a strong brand, enable them to charge a premium, and they had a lot of growth, both same-store and also in terms of store count. And that thesis largely fell apart over the last three years. Very fortunately, Amazon (AMZN -1.64%) came in and bought up Whole Foods, so a lot of people recouped some of their losses, maybe even made a gain. You and I had both sold before then, so we didn't, which is fine.

Lewis: There's a separate lesson there.

Douglass: Yeah, we're not bitter. [laughs] But when thinking about grocery stores at a whole, first off, I do recognize that they are consumer-goods companies, maybe not tech companies, but there's a tech angle here.

Lewis: We're going to bring it around.

Douglass: We'll get there. But grocery stores are low-margin businesses because they're so darn commoditized. Sure, there are tiers of stores. Harris Teeter and Wegmans operate on a different paradigm in a lot of ways than the giant Kroger and Food Lion, and then you have your true discounters like Aldi. But they're in competition with so many other businesses. Think retail pharmacies like CVS and Walgreens, think dollar stores, big-box stores like Target, Wal-Mart, the warehouse clubs like Costco and BJ's. You just have a ton of competition, and that's a good thing for consumers. It's a bad thing for margins.

Lewis: Yeah, it's really tough to make the numbers work, particularly when you can buy a bunch of bananas or Life cereal at most grocers. It's kind of hard to charge much more for it than the place down the street is.

Douglass: Yeah. You can get a little bit on specialty products, like a particularly nice cheese or something like that, but that's not where most of your volume is going to come from. It's going to come from stuff like milk.

Lewis: And you mentioned that we were going to bring this around to tech. I'm going to try to do it here. [laughs] 

Douglass: Do it. Here we go. Turn the ship. 

Lewis: You talked about Amazon's acquisition of Whole Foods. I do not think the grocery business is going away anytime soon.

Douglass: No.

Lewis: Particularly for things like milk, I think people are going to be happy to go to the store and actually grab things they need quickly. But if a business is super low-margin, and someone can come in and totally disrupt it by being more convenient, that's a red flag. Just keep that in mind as these tech companies continue to get into further-afield businesses from whatever their core competencies are. I think that's one of the big lessons from the Amazon-Whole Foods acquisition.

Douglass: And one of the key things to think about with an Amazon or Blue Apron or some of these other companies that are operating in this space, and are frankly disrupting -- Amazon Fresh, Amazon delivery, if they're able to really win at that, that could be enormous -- is that they have a footprint advantage. They don't have to operate all of this really expensive retail space. That gives them a cost advantage. If something is low-margin and kind of commoditized, a low-cost operator wins. That could end up being somebody like an Amazon. Now, today, tomorrow, five years from now, hard to say. That's not to say -- again, I would agree with you, I don't think grocery stores are going out of business. But there's a difference between surviving and prospering.

Lewis: Exactly, when you're thinking about market-beating returns.

Douglass: Right. We're in the stock market because we want to win, we want to make money. Plenty of companies plod along and survive; relatively few prosper. I think, for me, that's the kind of investing that I want to do. And hopefully you're listening to the Tech show because you do, too.

Lewis: Yeah. One more point on that -- I think for Amazon or any of these big tech companies, to offer more products that roll people into a membership-type option, it's peanuts for them. They are happy to offer groceries at super low margin because they already have logistics that are built out to work with all that fulfillment. If it means they get more people into their Prime ecosystem, they're psyched about it. If you're competing against super-deep-pocketed competitors, and it doesn't really cost much for them, and it's no skin off their nose to enter that market, that's kind of dangerous.

Douglass: Incredibly.

Lewis: So, Michael, I have to ask you, in addition to these investing and personal-finance never-will-I-evers, do you have a person Never Will I Ever?

Douglass: Yeah. Never will I ever grow a man bun.

Lewis: That is a personal jab.

Douglass: [laughs] No, I think it looked good on you. It would not look good on me. I'll also say, I will personally never run a marathon. I played racquetball in college and messed up my knees, and while I've recovered nicely and I'm fully functional today, I'm not so great at the whole ... what's it called?

Lewis: High-intensity training?

Douglass: Yeah, high-impact workouts, that's what I was looking for. So, running in general is not in the cards for me.

Lewis: In addition to financial health, it's very important to take care of your personal health.

Douglass: Absolutely.

Lewis: Austin Morgan, our man behind the glass, what about you/ Any never-will-I-evers for our listeners?

Austin Morgan: Never will I ever eat at a Waffle House after midnight.

Lewis: That's a good rule. [laughs] There are a lot of things post-midnight that are not good ideas.

Morgan: Waffle House is one of them.

Lewis: Waffle House is one of them.

Morgan: It's one of the top five.

Lewis: Yeah. Although if you're not driving to the Waffle House, it might be good. You could soak up some of whatever you ingested prior to the Waffle House.

Morgan: Yeah. I just hope everything at the Waffle House goes smoothly.

Lewis: [laughs] This is true. My Never Will I Ever on a personal level is, never will I ever let my passport expire. That is one of my mom's pieces of wisdom. Always have an active passport, because you never know what opportunities are going to come up to go do some traveling, and you always want to be ready and able to do it.

Douglass: That's very wholesome.

Lewis: It is wholesome, right?

Morgan: I actually don't have a passport.

Lewis: Are you serious?

Morgan: Yeah.

Lewis: You should get on that, man.

Morgan: There have been a couple of times where I'm like, "I'm going to get a passport," and I have the photo and everything, and then I just never got it.

Douglass: Getting over the bureaucratic hump of making it happen is kind of tough. What I found helped me was scheduling a trip and saying, "Well, it's either the passport or I'm throwing $1,300 away."

Morgan: That's a good way to solve that problem.

Douglass: Yeah, force yourself into a painful money loss if you don't do it.

Lewis: Michael Douglass and I have talked about accountability buddies for goals and resolutions. Austin, I'm happy to be your accountability buddy to getting your passport up to date and ready to roll.

Morgan: It's not that it's not up to date. It just doesn't exist.

Lewis: I'm happy to make sure that it exists.

Douglass: And then I will follow up to make sure that it's up to date every year from now until whenever.

Lewis: This is your process of becoming an adult. You're a homeowner. You have a dog.

Morgan: I'm a homeowner. I have a dog. I just don't have a passport.

Douglass: You know what? To be fair, two out of three ain't bad.

Lewis: We're going to check in on that in a little bit and see. But I will goad Austin Morgan into getting his passport.

Morgan: Fair enough.

Lewis: Michael, thank you so much for hopping on the show. I love how much we got to include Austin in this discussion.

Douglass: Yeah, this is exciting.

Lewis: Yeah. Anything else before I let you go?

Douglass: I think that's it. Thanks for having me.

Lewis: Can't wait for that Bonchon.

Douglass: Me, neither. Listeners, that does it for this episode of Industry Focus. If you have any questions, or you just want to reach out and say "Hey," shoot us an email at [email protected], or you can always tweet us, @MFIndustryFocus. If you're looking for more of our stuff, subscribe on iTunes or check out the Fool's family of shows at fool.com/podcasts.

As always, people in the program may own companies discussed on the show, and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell anything based solely on what you hear. Thanks to Austin Morgan for all his work behind the glass. For Michael Douglass, I'm Dylan Lewis. Thanks for listening, and Fool on!