Is Investing in IPO Stocks Worth the Risk?

There can certainly be advantages to investing in a newly public company, but sometimes the risks far outweigh the benefits. In this segment of Backstage Pass, recorded on Nov. 15, Motley Fool contributors Danny Vena, Jason Hall, and Rachel Warren discuss IPO investing, the downfall of newly public Casper (CSPR) stock, and what investors need to consider before they jump into this space.

Danny Vena: It's not easy to make a company successful, and not every company should go public, and the metric that we talked about last week was something in the neighborhood of 3.4% of IPOs are responsible for all of the economic gains from IPOs over a 10-year period. 3.4%, essentially what that means is 96% of IPOs are going to be unsuccessful.

They're either going to be flat, or essentially like Casper, they're going to be a dumpster fire from day 1. It's not going to get any better, shareholders are going to lose money, and the company is going to be taken private at a quarter of its value from before its IPO. Any thoughts on that?

Jason Hall: Ow, that's my thoughts. The purple line here, this is absolutely brutal.

Rachel Warren: Wow.

Jason Hall: Getting in is highly overrated. I think that's all I can say. Getting in early as highly overrated, and that data says it out there.

Fools that are watching here on Backstage are members of a lot of our Real Money portfolios, and those rules of winning, like they talk about things a large portion of your stocks are going to underperform and that your 80% of your gains or more are going to come from 20% or fewer of your investments.

Danny just quoted it. The margin of error is even higher and harder the closer to IPO you buy.

Danny Vena: Which is why my general rule that you are well aware of, Jason, is I wait at least two quarters. I want to see trends established as a public company, not when the company is going public, and they're putting their best foot forward, and they're making their regulatory filings as pretty as they are legally allowed to.

Not saying that any of it is dishonest, but there's putting their best foot forward. I want to see what they look like, warts and all. Show me what they look like when they are out there doing stuff day to day and doing their business.

What does it look like when things get ugly? Casper is a perfect example of what things look like when it gets ugly. Rachel?

Rachel Warren: I think sometimes there's this thought among investors that maybe it's better to get into the company early in, and if you invest in a company that's already massive and established that maybe your potential for growth isn't as high. I think that this is just a perfect example of why being first isn't always better.

Sometimes it is OK to wait to see. Like in my case, I'm a new investor, and when I bought my first stock, I bought very established companies ranging from Amazon to Apple to Johnson & Johnson.

I think that really great quality businesses that keep generating growth, that does translate to share price gains, and like this stock today is having this insane jump, but it's not because of anything great that's really happening with the company, so I think, again, looking beyond share price, it's just one indicator that can be caused by so many different factors. That's just a sad story.

Jason Hall: I'm going to steal something from Nick Sciple, our colleague. He put on Twitter, "Buying a stock that goes up 20% when they report earnings doesn't make you a great investor, any more than the stock falling 20% makes you a bad investor."

It just means nobody knows what it's worth, and that's the reality. There's so much speculation in the short-term that can drive extreme volatility.

These failures are going to happen. I want to answer one quick question here, guys. Just what I'm thinking about it because it ties into that volatility thing.

Jerry shared a question earlier about TriplePoint Venture Growth, ticker TPVG, saying when investing in the world of venture capital, which is actually what TriplePoint Venture Growth does, what do you think about buying TPVG that pays a 7.6% dividend while you wait for new stocks to skyrocket.

The same thing that makes me caution anybody that considers buying any stock while you're waiting for something to happen and that you don't know what's going to happen in the short-term with stocks. It has done really well this year. It has done really well since the bottom in 2020, but this is a stock that has been very volatile.

You look at the times that it was, let's see if I can find a percent, off of its all-time high. This is a stock that's been a hell of a lot of time, 22% to 25% or more below its all-time high.

Danny Vena: It looks like 75%, more like 80% off its all-time high last year. Although in all fairness, we did see a lot of that going into the pandemic, stocks dropping precipitously.

Jason Hall: The point is that with stocks, short-term volatility risk is your risk if you're making a short-term bet. You just don't know. You have to take in that risk into consideration.

Danny Vena: I think this is something that we can all testify to. If you look at some of the most successful companies of our age, if you look at some of the ones Rachel mentioned, Apple and Amazon, if you look at some other companies like Shopify and MercadoLibre, ones that are in my ballpark.

One of the things you hear investors say so often is, I think I missed the boat on that, the train has already left the station, that stocks already up 100%. For instance, Airbnb. I missed that 100% run-up on the first day.

I've already missed the opportunity is the prevailing thought. One of the things that I like to say is go back and look at the stock chart of any of these companies after they've gone up 100% and see what they've done since that. 

For instance, Tesla was a company that I only bought shares in twice very early on, and I haven't bought anymore since then for a variety of reasons. But this is a stock that for me is something like a 50 plus bagger. I bought it after it had already gone up 100%. 

For a company that is disruptive, that is a game changer, you can buy it after the stock has already gone up 100% You don't have to worry that you've already missed out or the train has already left the station because a lot of these stocks, not only have they gone up multitude of time since then, but they will continue to go up for the next five to 10 years. Rachel?

Jason Hall: I'm going to hit a couple of things real quick here.

Danny Vena: Okay, Jason.

Jason Hall: Bill Brown, I think when you say Confluent is very expensive, I think you maybe you're talking about valuation here. It trades for about 50 times trailing sales. It has a $21 billion market cap. This is a growth story here. $21 billion dollar market cap, five years from now, it's going to be a $100-billion market.

Its growing revenue, about 60% a year, and its biggest growth opportunity, Confluent Cloud, grew 175% year-over-year. You are betting that they're going to continue to take market share, and it's going to be a big winner if they do that, even though it is expensive right now. That's the thing. If they execute, this is going to be a big winner, I think.

Danny Vena: It's interesting. A lot of people think that when you're investing in these high-growth stories, traditional valuation metrics are more than useless. [LAUGHTER]

You can't necessarily go by that. What I'm going to do here is I want Rachel to have the last word because I know there has been more than once that she has been cut off by us.

Rachel Warren: [LAUGHTER] You guys are great.

Danny Vena: Rachel, thoughts?

Rachel Warren: Thoughts on this, look, I agree with everything you both were saying. I think that every investor has a slightly different take on the long-term investing strategy.

Some might have a far higher tolerance for risk than others, that's OK. But I think that this is something we've talked about a lot, that winners do keep on generally winning, and that's been my strategy with investing.

I think if you're going to perhaps invest in "riskier companies," whether IPO stock or just a company in a particularly volatile industry, consider maybe that could be a smaller part of an overall portfolio, but you don't need to invest in those kinds of stocks to have a really high-performing market-beating portfolio, and I think that's a key takeaway here for sure.