IPOs' Dirty Little Secret

After a downturn following the market's 2001 implosion, Forbes reports that the IPO market is heating back up. According to a recent article, there were 11 offerings in January that raised $1.8 billion.

How'd these companies do? Pretty well. They posted average first-day gains of 16%, according to Forbes, including Chipotle Mexican Grill's (NYSE:CMG) nearly 110% gain since offer and H&E Equipment Services' (NASDAQ:HEES) more than 50% gain.

But recent IPO optimism is not confined to January:

These IPOs have all rewarded those investors who were fortunate enough to get in at the IPO price (most often the investment banking firms and venture capitalists) with substantial short-term gains. But IPOs have a dirty little secret: Buying a stock at or even near its IPO is often a terrible idea. Yochanan Shachmurove studied 2,895 IPOs between 1968 and 1998 and found that the average annualized returns were a shockingly low -45%. Many IPOs, despite so much front-end optimism, just flat out fail to perform over long periods of time.

The IPO forecast
That historical performance is not dissuading investors or underwriters. Offerings are expected to remain popular for the rest of 2006. This, after all, is an optimistic market, and small companies and venture capital firms are confident they can get good prices for their equity.

What does that mean for us individual investors? It means that we can expect to overpay, potentially hurting our long-term returns. Expensive small-cap growth stocks underperform their value counterparts by more than six percentage points per year, according to Fama and French data, and that can really add up over time.

So what's the big deal?
Despite the data, investors love IPOs. After all, getting in on an IPO means potentially being the first to find the Next Big Thing.

Yet IPOs are one of the trickiest areas of the market to analyze. They have great stories, are marketed by their underwriters, and, without histories as public companies, produce financials that can be difficult to project forward in a valuation model.

Yet the rewards can be incredible. Indeed, the 10 best stocks of the past decade were all small caps -- just like the seven IPOs above.

The Foolish bottom line
While it's worth your investment to buy shares of the very best small companies on the market, don't chase hot or newly public shares. They're volatile and difficult to value. Instead, remember that the two keys to earning great returns from small caps are:

1. Never buy the hype.
2. Never overpay.

These are two of our guiding principles at Motley Fool Hidden Gems, where we recommend the market's best small caps to our members. In nearly three years, our companies have posted 38% average returns -- besting the market by more than 25 percentage points. I invite you to join us.

Tim Hanson does not own shares of any company mentioned. No Fool is too cool for disclosure ... and Tim's pretty darn cool.