Few things can work investors into a frenzy like the prospect of a company's first foray into the stock market. Feeding the excitement have been spectacular debuts like that of Internet software company Netscape in 1995. Shares were priced at $28 each, but due to high demand they began trading at an incredible $71 per share before settling down to $58 per share at the end of the day.
There are many reasons why Fools should avoid IPOs:
- They're considerably more volatile than other stocks.
- Many are young companies with unproven operating histories. Better to let a firm get a few quarters under its belt before investing.
- IPOs tend to underperform. Finance professors Tim Loughran and Jay R. Ritter examined the performance of 4,753 IPOs between 1970 and 1990. In their second six months on the market, the new issues lost 1.1% vs. a 3.4% gain for other firms of the same size. In the five years following the offering, the average annual return for IPOs was 5.1% vs. 11.8% for their counterparts.
There's no need to scramble for IPOs. Although many do skyrocket in value in their first days, others don't. And, even the much-hyped high-flyers often come back down to earth, permitting Fools to buy when the shares are priced closer to their fair value. While shares of Netscape approached $90 each in its first few months, they traded around $20 a few years later. When America Online (now Time Warner
There are many great companies that have been trading for a year or longer; we generally prefer to dig for our truffles in that field instead of chasing after IPOs.