For Most Investors, IPO Should Stand for “Initially, Pause -- OK?"

In the glamorous society of Wall Street, initial public offerings are a bit like debutantes headed for their coming-out parties. They've done everything they can to make themselves attractive, and they are so full of potential. And with all the buzz around them -- not to mention the media coverage some get when their share prices bounce on their first trading day -- it's natural that retail investors would be intrigued.

In this mailbag segment from the Rule Breaker Investing podcast, host and Motley Fool co-founder David Gardner offers some advice to a listener who is anticipating some of the coming arrivals in 2019's large IPO class, which will feature some well-known tech companies. And not to give his answer away too much, but when it comes to IPOs, real Fools do not rush in.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on April 24, 2019.

David Gardner: Rule Breaker mailbag item No. 1. First up this month, Surinder Punjya. Dr. Punjya, thank you for your note! "David, I'm a big fan of financial literacy. I've been educating myself by reading books and also listening to the podcast. I'm reading the book 100 to 1 right now." I haven't read that myself. "Just finished reading 25 years' of Buffett annual letters." Dr. Punjya, I've also not done that myself. "I actually get excited each week and look forward to the daily and weekly podcasts, including Market Foolery, Industry Focus." These are all Motley Fool podcasts, thank you! "And, of course, Rule Breaker Investing." This is very kind! "You are my hero, thank you for your invaluable service that you provide.

"I wish I had joined 10 years ago. I did come across the service, but the name kept me away. I am such a fool." That does happen, by the way. The Motley Fool name doesn't exactly suggest Schwab-like, Vanguard-like trust to people. Some people think that we're just joking until they eventually look a second or third time, or a friend mentions it to them. Anyway, you say: "I finally took the plunge a little over a year ago. I'm glad I did. Glad to be a Fool. Can we have a commentary on IPOs? There's a flood of them coming each week. Fool on. Sincerely, Surinder."

Well, I guess I want to say three quick things about IPOs. The first is, I want to make sure that we're all clear on what an IPO is. IPO stands for the phrase "initial public offering." That's basically when companies that were previously private, started by an entrepreneur, probably venture capital backed or sometimes family money backed. The company gets big enough that it decides it wants to sell a portion of itself to the public at large through the New York Stock Exchange or the NASDAQ or another exchange, sell a portion of itself to you and me, armchair investors. And we can become part owners of that company, too. The company is born on the public markets. Day one, when a company IPOs -- yes, it's a verb, too. Doesn't really make that much sense, does it? Initial public offerings, day one, when it IPOs, that company has a ticker symbol, and it becomes a stock. And you and I can buy it. So No. 1, just wanted to define our term and make sure we're all clear on what an IPO is.

Point No. 2, none of us has to buy them. Not one of us ever has to buy an IPO. Rarely have I ever bought a stock within the first day, let alone month that that stock came public. I wouldn't say I've never done it. I'd have to search my memory. I've been investing for 34 years now as an individual investor since taking over my own account at age 18. I don't think that I've ever bought a company on the first day or two of it being traded. In part, that's because those companies tend to have their stocks, if they're good companies, zoom way up. There's a lot of intense interest, especially as Dr. Punjya is mentioning, in this time, where you're finding out about Zoom coming public and Lyft coming public and Uber, and Slack, I think, might come public here in 2019. And the list goes on of interesting companies -- Beyond Meat, I think, is going public in 2019. There are a lot of interesting companies that weren't going public in 2018, '17 or '16. There's a little bit of pent-up demand. For whatever reason, a lot of them are going public this year. There's news stories around them. Their stocks typically come out and zoom, just like Zoom's IPO did last week, the stock up 70% in one day.

But one of the reasons I don't typically buy them at IPO is because you and I don't get that 70% gain. You hear the news say the stock was up 70%. But what's actually happening there is, the company gaps up on the opening. It had an intended opening price. But from the first second of trading, buyers have bid it up. So, instead of a company -- I'm making this up -- coming public at $30, all of a sudden, the first trade will be at $42. And you'll hear, "Wow, that stock's up more than 30%!" Nobody profited as a public stock market investor from that. Only the people who owned the shares the day or week or three years before, the founders of the company and the venture capital investors. Only those people owned the stock at $30 or below that. Everybody else is starting to buy it at $42. And often, within six months, those stocks are back down to where they initially traded or lower than that, studies have shown. So point No. 2: you really don't have to buy any IPO.

In fact, here's a little mental exercise I like to go through, and I did this recently on the show -- I started to suggest, what are some other stocks you could buy instead of that IPO? I often can find companies that I like just as much, if not more, that are surer things, in my mind, than some of the new births that are occurring on the public markets. Not to say you shouldn't be excited about a great company like Uber or an interesting IPO like Beyond Meat. But it is to say, you and I don't have to buy them. We can do really well as investors without getting caught up in that IPO hype.

And then point No. 3: if you are interested in an IPO -- I mean, I love it when a cool new company that I'm interested in is born in the public markets. I was really fascinated by Match Group when it came public a few years ago. It's been one of our better stock picks. I would say this: Consider just buying a small initial position. Then maybe add to that over time. You know that we like to add to our winners. We don't so-called double down on our losers as Rule Breaker investors, but consider that. You can toe-dip. You can start with a small position. And then, if you like how the company's developing, then maybe go from there.

Oh, my gosh, is it Bill Mann, the global director of small-cap research, in Fool studios?

Bill Mann: I snuck in. How are you, David?

Gardner: You didn't sneak in, Bill. That really understates it. We laid out a red carpet, we gave you free Starbucks.

Mann: That's true.

Gardner: It's an honor to have you! You were here just a few weeks ago. I have a mailbag item that was spawned by that. But before we get to that, Bill, I wanted to just ask you, any quick thoughts from you on IPOs?

Mann: I think a lot of people get very excited by them. Obviously, it's an event. But the thing that you have to recognize about investing is that once a company comes public, it's public until... you'd want to say forever, but until it goes private or whatever. There's plenty of time. One company that we all know and love is Pinterest. One thing that I like to point out, just thinking about Pinterest, for example, is that when it came public, it popped. Then the stock dropped a lot, because I think they struggled a little bit by virtue of now being in the light of having to report quarterly. Companies really change a little bit once they become public. Never feel like you're missing out on a public offering simply because you've missed the IPO.

Gardner: You know what's funny? Here's just a quick analogy, Bill. This is not taking a shot at Pinterest, a company I admire. It's just more the humor around IPOs. Are IPOs kind of like new cars? They're really shiny, and as soon as you drive them off the lot, seconds later, they're down 30% a lot of the time?

Mann: [laughs] A lot of the time, they are. You have to be pretty lucky for it not to drop at some point. The great news about most IPOs, or a lot of IPOs, is that they don't keep going down like your shiny new car. But...

Gardner: Fortunately Facebook did come back. I know there's a lot of Motley Fool money long-term riding on a company like that, where we waited for it to drop some and then bought.

Mann: That's right.