Are you waiting for the initial public offerings of Facebook, Groupon, and Zynga with bated breath? You're not alone -- but you shouldn't get so excited.
Some IPOs do surge significantly on their first day, as eBay (Nasdaq: EBAY) did. Priced initially at $18, the stock debuted at $53.50 in 1998, and closed that day at $47.38. Other IPOs, like Amazon.com (Nasdaq: AMZN), take a few months before they're really off and running. Amazon shares began trading in the low $20s in May 1997, dipped into the teens on their first days, but topped $50 by September of that year.
However, getting in on a new investment early often isn't the best idea.
Startling studies
You might be surprised to hear this, but most IPOs underperform the market in their first few years. And that's not just from one study, either:
- Tim Loughran and Jay Ritter, studying IPOs from 1970 to 1990, reported an average annual return of 5% for IPOs in the first five years after issuance, vs. 12% for comparably sized companies.
- Reena Aggarwal and Pietra Rivoli examined roughly 1,600 IPOs between 1977 and 1985, and found that on average, they underperformed the market by nearly 14% over their first year of trading.
- Daniel Hoechle and Markus Schmid charted more than 7,000 IPOs that took place between 1975 and 2005, and again found underperformance.
- Research from earlier periods and non-U.S. regions supports these findings.
Doubtful drooling
Many folks have been champing at the bit to invest in new issues such as online real estate marketplace Zillow (Nasdaq: Z), which debuted in July; Chinese Internet company Qihoo 360 Technology (NYSE: QIHU), which bowed in March; and Renren (NYSE: RENN), touted as a Chinese Facebook, which entered the market in May.
It makes sense to be interested in these companies: China is clearly a huge market, with a growing middle class that will increasingly move online, and and real estate is a vast sector that can benefit from online conveniences.
But these aren't necessarily slam-dunks, and their shares are not yet in orbit. Realtor.com's parent, Move, hasn't found great success in the market, and though Zillow offers reasons to be hopeful, it remains unprofitable at this point. Zillow shares opened at $57, closed their first day below $36, and were recently trading in the low $20s.
Renren and Qihoo surged on their market debuts, only to pull back quickly afterward. Fellow Fool Anders Bylund argues that Qihoo seems subject to market manipulation and is heavily shorted. Renren recently posted strong growth in online advertising, topping the growth of Chinese online ad-sellers Baidu (Nasdaq: BIDU) and Sohu.com (Nasdaq: SOHU), but its profits aren't yet surging.
No need to rush
It's easy to brush aside the lessons of history and researchers' studies with a few handy anecdotal exceptions. Sure, if you bought shares of Amazon.com for around $1.50 apiece (split-adjusted) in their first month, you'd have increased your wealth more than 130-fold. But if you waited five years, you'd still have seen your shares rise from around $18 per stub to more than $200 in 2011.
Earlier isn't always better: Amazon.com shares averaged 35% annual growth over the past decade, 46% over the past five years, and 55% over the past two. The company was exciting many years ago, but recent years have added more reasons for great investor expectations, such as the success of the Kindle. The company may even give Groupon a run for its money via its new AmazonLocal service.
There are good reasons to wait before jumping into an IPO. Debuting companies are typically young and trying to grow rapidly. Their IPOs often generate a big cash infusion to fuel that growth and/or reward early inside investors. By definition, these companies don't typically have several years' worth of audited financial statements that you can study. They're frequently in rapidly changing industries, so it's often smart to give them a chance to prove themselves, and to give their new shares a chance to settle down. Despite the excitement over Groupon, its business lacks a wide protective moat. Even Facebook, despite its dominance, may end up eclipsed by a competitor.
If you're not fairly sure what a company's near future will look like, think twice before investing in it. There are lots of exciting stocks in the market -- you don't need to take outsized risks with IPOs. Even if you're right about a company that looks great today, it will likely look great down the road, too.
- Add Zillow to My Watchlist.
- Add Sohu.com to My Watchlist.
- Add Renren American Depositary to My Watchlist.
- Add Qihoo 360 Technology A to My Watchlist.
- Add Move to My Watchlist.
- Add eBay to My Watchlist.
- Add Baidu to My Watchlist.
- Add Amazon.com to My Watchlist.
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