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Ask The Experts: Why is Wall Street All Atwitter About IPOs?

by John S Kiernan on November 14, 2013

IPOWall Street investors who were active in the late 1990s no doubt recall the “dot-com boom” that saw countless Internet companies – with no profits – make initial public offerings (IPOs) and have their stock prices rocket to the stratosphere.

Investors poured money into these companies based on “potential” – potential for a cornerstone role in online life and therefore potential to make a killing. But it all came crashing down in 2000. The bubble burst and the IPO market was depressed for years thereafter due to a combination of a downtrodden economy and investor fears.

The Facebook debacle of 2012 didn’t help much either, but in that case it was Wall Street “insiders” who got burned as the stock sank in from its initial offer price. Individual investors buying in the open market were able to snap up shares at what now appear to be bargain prices.

2013 is another story entirely. Not only has the IPO market been on fire this year, with roughly 50% more companies having hit the market through October compared to last year, but this crop of newly traded companies also has some big-name headliners, including Potbelly, Remax Realtors, Seaworld Entertainment, and of course, Twitter.

But what should we make of this apparent IPO boom? Are any of these newly available stocks – particularly the big names of the bunch – good buys? WalletHub consulted a number of experts in the fields of finance, entrepreneurship, and investing for insight into those matters and more.

IPOs Mimic the Market

The flurry of activity witnessed in the IPO market thus far in 2013 is a product of the stock market’s strong overall performance, experts say. Not only does a strong market promote higher valuations, but it also fosters greater interest in a given stock among consumers on the retail market.

“Rising stock markets are fueled by demand for stocks. This increase in demand creates an opportune time to go public,” Keith Jakob and Tony Crawford, a pair of finance professors at the University of Montana, recently told CardHub. “For a company planning an IPO, a ‘hot’ market means a higher valuation for the company’s shares, which leads to greater IPO proceeds for the issuing company or its selling shareholders. For the investment banker ‘underwriters’ of IPOs, a strong market means a stronger market reception for IPO shares – reducing the banks' issue risk.”

Indeed, “despite the gloomy headlines in the press about government budgets and war abroad,” says Gerard Hoberg, associate professor of finance at the University of Maryland, “the market is near an all-time high.” As of the end of the trading day on November 4, the S&P 500 was up 20.89% year to date, the Dow Jones Industrial Average was up 16.60%, and the NASDAQ Composite Index was up 26.49%.

As a result, the IPO floodgates have effectively re-opened as companies who were biding their time waiting for a good point of entry have jumped at recently attractive market conditions. That, however, doesn’t mean that either the economy or the IPO market has reached its full potential.

“The scarcity of IPOs during the last five years has created a bit of an IPO backlog. Some 2013 IPOs might have gone public in 2010 or 2011 if market conditions were better,” says Timothy Loughran, C.R. Smith Professor of Finance in the University of Notre Dame's Mendoza College of Business. “Although 2013 is going to have strong IPO volume compared to the last five years, recall that 676 IPOs went public back in 1996. We are quite far from having that type of IPO volume anytime soon.”

2013 IPOs Displaying Impressive Performance

There were 185 IPOs through Nov. 3, and this year’s crop of newly traded companies has performed quite well relative to the overall market. More than 70% of the 2013 IPOs have posted gains since their issuance, and the class is up more than 30% altogether.

That’s only part of the story, though.

“IPO performance is generally broken into two categories: the first day ‘pop,’ and more long-term performance,” Jakob & Crawford say. “While not all IPOs enjoy a first day pop (witness Facebook last year), on average about 75% of all IPOs experience a first day increase in price. As for long-term performance, most academic literature suggests that IPO firms on average actually underperform for the next several years after the IPO.”

The first-day pop for IPOs this year has been around 16%, but that figure requires context in order to be fully understood.

“The average level of IPO underpricing for any given year tends to move up and down along with the number and magnitude of the issues in the year,” according to the pair of University of Montana professors. “In 1999 the mean first day return was 70.9% and there were 477 IPOs with gross proceeds of nearly $65 Billion. After the dotcom bust in 2002 there were only 66 issues with $22 Billion in proceeds and first day returns fell to around 9%.”

High-Profile New Entries

As prodigious as the 2013 IPO market has been from a pure numbers standpoint, the mainstream buzz generated by a number of high-profile offerings has been perhaps even more impressive. Just consider the following big names that have gone public this year:

  • Noodles & Co.
  • Panera Bread
  • Potbelly Sandwich Shop
  • ING US
  • Remax Realtors
  • Seaworld Entertainment
  • Sprouts Farmers Market

In addition to Twitter – which hit the market on Thursday Nov. 7 – there are a number of other major players expected to make their first public offerings in the next few months. Among them, according to widespread speculation, are the mobile phone credit card processing company Square and the cloud-based file sharing company Dropbox.

“More social media and tech companies are waiting in the wings,” says Aswath Damodaran, the Kerschner Family Chair in Finance Education in New York University’s Leonard N. Stern School of Business.

Evaluating an IPO

With so many high-profile offerings luring investors into the market, it’s fair to wonder if there's any money to be made investing in IPOs and, if so, how investors should go about it.

Amiyatosh Purnanandam, associate professor of business at the University of Michigan, preaches caution above all else because individual investors are unlikely to get any shares through the initial offering and must therefore buy on the secondary market.

“Institutional investors get that as part of the underwriter's book-building process,” he said. “But if you want to invest in it, I would recommend looking at fundamentals of the company. Look at earnings and beware of ‘excessive growth.’ IPOs with good earnings do better in long run. Growth IPOs are more risky. A good combination will be to look for IPOs with good earnings and moderate growth.”

Building on those ideas, Loughran says that like any investment, buying a stock as it begins trading requires careful research.

“Understanding the IPO’s business model is critical for success,” he said, “Since many IPOs have never produced positive earnings, it is important to properly evaluate the chances of the IPO eventually becoming profitable. For firms like Potbelly or Sprouts Farmers Market, it might be helpful if investors visited local stores to gauge employee morale and try out their products/services.”

Ultimately, making a rational decision about a particular newly-minted stock also necessitates cutting through the hype that influences initial investor sentiment, yet is sure to fade away in time.

“Focus on actual performance,” Tim R. Holcomb, assistant professor of management and entrepreneurship at Florida State University, says. “Take note of company and industry sector trends. Take time to assess risk prospects. It’s very easy for individual investors to get caught up in the surge of ‘propaganda’ about the potential for a significant upside from IPOs.”

That’s why Damodaran recommends that investors “wait for a couple of years for a bad surprise (and there will be one, almost always) and then buy the stock, but as one of your riskier investments.”

Want more expert insights on companies like Twitter and Potbelly as well as the state of the IPO market and the best ways to play it? Just keep reading!

Meet Our Experts

  1. Twitter (TWTR)
  2. Potbelly (PBPB)
  3. Active 2013 IPO Market
  4. Playing the IPO Market

*Please note that expert interviews took place both before and after the Twitter IPO, and thus the tone of their responses may vary.

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  • Reena Aggarwal McDonough Professor of Business Administration & Director of the Georgetown Center for Financial Markets and Policy at Georgetown University; FBR & Co. Board Member
  • Bharat A. Jain Professor of Finance in the College of Business and Economics at Towson University
  • Richard D. Marcus Associate Professor of Finance in the University of Wisconsin – Milwaukee’s Lubar School of Business
  • Jacqueline L. Garner John Nutie and Edie Dowdle Professor of Finance in the Mississippi State University College of Business
  • Tim R. Holcomb Jim Moran Assistant Professor of Management and Entrepreneurship in The Florida State University College of Business
  • R. Michael Holmes Jr. Assistant Professor of Management with the Jim Moran Institute for Global Entrepreneurship in The Florida State University College of Business
  • Belinda Mucklow Senior Lecturer in Finance with the University of Wisconsin School of Business
  • Keith Jakob Donald and Carol Jean Byrnes Professor of Finance in the University of Montana’s School of Business Administration
  • Tony Crawford Associate Professor of Finance in the University of Montana’s School of Business Administration
  • Gerard Hoberg Associate Professor of Finance in the Robert H. Smith School of Business at the University of Maryland
  • Timothy Loughran C.R. Smith Professor of Finance in the Mendoza College of Business at the University of Notre Dame
  • Amiyatosh Purnanandamam Michael R. and Mary Kay Hallman Fellow in the Ross School of Business at the University of Michigan
  • James C. Brau Professor of Finance in the Marriott School of Business at Brigham Young University

Reena Aggarwal

McDonough Professor of Business Administration & Director of the Georgetown Center for Financial Markets and Policy at Georgetown University; FBR & Co. Board Member
Reena Aggarwal
Twitter

There was a lot of institutional investor demand for Twitter, and it popped on the first day of trading. Supply was quite restricted, however, as they sold a very small number of shares.

Active 2013 IPO Market

The overall market has performed well, all the major indexes are up by a very healthy amount in 2013. There is a lot of pent-up supply with issuers wanting to go public, some of it driven by private equity looking for exits. Investors are willing to once again take more risk. Therefore, this is a great time to go public. IPOs this year have done quite well overall and many of them have doubled on the first day of trading. We haven't seen this kind of performance since a long time. I hope we don't build-up another bubble.

Playing the IPO Market

IPOs are still very risky – a lot of the valuation is driven by future potential for profits and cash flows. It’s not easy for individual investors to evaluate them. I would warn individual investors to be particularly careful buying in the aftermarket when the price has gone up by a lot. The tendency is to buy in the aftermarket if you don’t get initial allocation.

Bharat A. Jain

Professor of Finance in the College of Business and Economics at Towson University
Bharat A. Jain
Twitter

I believe both Potbelly and Twitter are both priced to perfection and there is unlikely to be any significant upside in the near term. An IPO can be considered successful if it is trading above its open price 12-18 months after the IPO.

Active 2013 IPO Market

IPOs tend to occur during periods when equity market conditions are favorable. Investors during these periods seem to be willing to pay high premiums for relatively unproven business models. Issuers and venture capitalists try and capitalize on these windows of opportunity and rush through their offerings. The most recent year has been exceptionally favorable for equity markets with the S&P 500 Index up over 20%. This has led to a large number of well received IPOs.

Playing the IPO Market

Individual investors should avoid investing directly in the IPO market. They usually do not receive allocations at the offering price and purchase shares in the aftermarket at inflated prices. They should invest through funds that are better positioned to get IPO allocations on favorable terms.

Richard D. Marcus

Associate Professor of Finance in the University of Wisconsin – Milwaukee’s Lubar School of Business
Richard D. Marcus
Twitter

Twitter (TWTR) has potentially even greater growth than PBPV but no record of profitability yet. So, with a P/E that is negative or not available, I think I would wait for proof that the firm can effectively monetize its many followers.

Potbelly

In general, firms that have had a track record of growth and been around a decade or so do better in IPO performance. Potbelly (PBPB) with a P/E of about 30 is priced a little lower than its first day. I think I’d invest in this franchise-growth firm, but its price is still higher than I would like. I’d wait.

Active 2013 IPO Market

IPOs, Mergers and Acquisitions, and other major corporate restructurings tend to move in waves. The number of IPOs are about 50% ahead of last year, but still lower than the pre-2008 IPO offerings. As the VIX, a measure of implied volatility of stocks has come down based on option prices, there seems to be greater appetite for investors to seek out new investments with somewhat higher risk. When the credit crunch hit in 2008, deals dried up. As this recovery continues, confidence in the future grows. Those who are the most optimistic are the ones who seek new investments.

The performance of IPOs this year includes spectacular winners and losers, with FUEL (Rocket Fuel) losing 99% of its value and XONE (ExOne) gaining 184%, nearly tripling in price. But this is often the case of IPOs – big winners and big losers, with somewhat more winners than losers. This is typical of this market. Historically, a portfolio of all IPOs tends to lag the market. Clearly, investing in the S&P500 index would outperform investing in all IPOs. Again, this is very typical.

Playing the IPO Market

Investors with a broker can sometimes be called by the broker with an IPO pitch, if that firm has a tranche of the shares to sell. If investors say yes to these pitches, they may get some shares. The first day initial return can often be 30%. My best advice would be to buy the IPO if available to you and then sell it ASAP if you can lock in a gain. Analysis of IPO long-term holding periods for every decade from 1920’s is that the average IPO lags the market over time. Yes, Google is way up to $1,035 from just $85 in 2004, but many other IPOs have dwindled to nothing. If you invest primarily in mutual funds or in a low cost electronic broker, it will be hard to get shares on the initial day. So, be happy, and invest in stocks you see have a future and don’t chase these first day deals.

Jacqueline L. Garner

John Nutie and Edie Dowdle Professor of Finance in the Mississippi State University College of Business
Jacqueline L. Garner
Twitter

According to U.S. Securities and Exchange Commission (SEC) filings, Twitter increased the offer price range for the ipo from $17 - $20 to $23 - $25. This appears to be the result of strong institutional demand. At the upper end of this price range, Twitter would be valued at $13.6 billion, which translates to about 43 times its revenue from 2012 based on SEC filings. If you consider the year-to-date (YTD) 2013 revenue and annualize it, the multiple is 27. At the midway point of 2013, Twitter had lost $69 million. If they perform similarly for the rest of the year, they will lose over $100 million but will be valued at $13.6 billion after the IPO.

Active 2013 IPO Market

Many IPOs have done very well this year in terms of what is called 'underpricing.' Underpricing is when the IPO’s offer price is below (or under) the price at the end of the first day of trading. Examples include The Container Store. It went public on November 1; it was priced at $18.00/share. At the end of the first day of trading, shares were $36.20/share. Potbelly went public in October, and its price also doubled.

Playing the IPO Market

Large IPOs are allocated by underwriters primarily to their large institutional investors. For the average individual, it is quite difficult to be granted share allocations in an IPO (i.e., to be able to buy the shares at the offer price). Often, if an individual can easily obtain an allocation, he/she should wonder why. This may mean the institutional investors are wary.

Tim R. Holcomb

Jim Moran Assistant Professor of Management and Entrepreneurship in The Florida State University College of Business
Tim R. Holcomb
Twitter

If the offering size is the measure of IPO success, then Twitter is sure to create a big splash when it enters the public market. Indeed, investment banks are vying aggressively to underwrite Twitter’s IPO, offering steep discounts to underwrite the offering . That said, Twitter’s biggest historical challenge and one that continues to dominate questions of future success is how the firm can monetize its model. Moreover, unlike Facebook, Twitter has yet to turn a profit. Combining the two “facts,” in my opinion, calls into question the long-term prospects for Twitter and raises serious questions about the sustainability of market value over time.

Active 2013 IPO Market

The 143 IPOs as of Oct 1 is about 47% ahead of the same period last year and on pace to be the best year for IPOs since 2007. Probably the biggest reason for the surge in initial offerings is the return of normality to the markets. Market volatility is down. Uncertainty is less pervasive. Optimism and confidence in market growth and opportunity are likely at their highest points since the mid- to late-2000s. As a result, there is evidence that generalist investors (e.g., mutual funds) have returned to the IPO market chasing speculative investment opportunities that hold greater promise to outperform the market.

Playing the IPO Market

Stick to facts. Focus on actual performance. Take note of company and industry sector trends. Take time to assess risk prospects (i.e., what could go wrong?). It’s very easy for individual investors to get caught up in the surge of “propaganda” about the potential for a significant upside from IPOs. Professional investors are susceptible as well. Facts suggest otherwise. Average returns mirror market returns. The key is to find investment candidates that demonstrate sustainable performance trends above industry norms. Of course, don’t get caught looking in the rearview mirror; that said, past performance is a good indicator future return.

R. Michael Holmes Jr.

Assistant Professor of Management with the Jim Moran Institute for Global Entrepreneurship in The Florida State University College of Business
R. Michael Holmes Jr.
Twitter

Inevitably, many people compare Twitter to Facebook. But, whereas the latter sought a high valuation and was perhaps overvalued, causing a downward spiral post IPO, Twitter has taken a more cautious approach. They are targeting a lower valuation, lower price range, and a more limited number of shares, perhaps to ensure that the shares are oversubscribed and to create the impression that the firm is undervalued, not overvalued.

However, in my view, Twitter (like Facebook) is overhyped because of its position in popular culture. To me, it might be a decent investment eventually, but it is less attractive than its hype suggests. Some analysts, for example, think that Twitter has limited opportunities for growth and earnings and lacks the ubiquitous presence that provides competitive advantage to many consumer IT firms (e.g., Google, Microsoft, and Apple). Twitter may grow, diversify, and find new revenue streams (as Ebay and Google have continued to do), but the attention its IPO is generating seems to be a function of its brand, not necessarily its attractiveness as an investment.

Potbelly

Because Potbelly was severely underpriced, insiders receiving shares at the offer price tended to make significant gains on the first day. About thirty days later, the stock is now trading below its end-of-first day closing price. This pattern is rather typical. In the Potbelly case, many investors who bought on the first day have lost 12% to 15%. And, in contrast to the first-day hype produced by its underpricing, many analysts have cooled on Potbelly and have assigned lukewarm ratings and recommendations (not always negative but not overly positive either). It is in a popular industry segment, for example, but many analysts believe it has mediocre-to-poor P/E ratios, debt, and margins (relative to rivals). Of course, the firm may do quite well. Only time can tell. But, we must ask ourselves the following: “Would we have believed this firm to be a strong investment if we had not been exposed to the publicity and hype surrounding it?” A similar question applies to Twitter.

Active 2013 IPO Market

Many studies suggest that IPOs trend with the overall performance of the stock market. Right now, the market is trading at or near all-time highs. Thus, it makes sense that there are many IPOs right now. In addition, the long-term downturn in the economy that began in 2007-2008 discouraged many firms from going public and discouraged investor interest in IPOs. In other words, companies that probably could have gone public years ago (e.g., LipoScience) probably waited for better market conditions. Likewise, most companies’ earnings trend with the economy, potentially increasing their attractiveness to investors as the economy improves. Revenue and earnings per share for Norwegian Cruise Lines, for example, are up roughly 20% and 150% since 2009 (the latter was negative in 2008), making the company appear much more attractive. Thus, there is probably pent up supply of, and demand for, IPOs.

It is difficult to tell how this year’s IPOs have done, because available metrics can mean many different things. For example, a firm could raise a lot of capital because (a) insiders sold more shares or (b) because outsiders valued the firm more highly (even too highly). Similarly, underpricing can mean (a) that the firm was undervalued and left money on the table or (b) that the firm is well-positioned to return to the market for a subsequent round of financing (e.g., Under Armor). Thus, it is probably best to wait at least a year to evaluate the performance of this year’s IPOs.

Playing the IPO Market

Like other stocks, consider basic fundamentals (e.g., price/earnings ratios, market-to-book ratios, etc.) and qualitative information (e.g., growth opportunities, risk factors, etc.) to evaluate IPO firms. However, due to their frequently short operating histories and previously private nature, there is often limited information about IPO firms. In addition, both underwriters and firms have short-term financial incentives to “dress up” the firm before it goes public. They may use accruals creatively, use more positive language in the prospectus, carefully select risk factors and their descriptions, use amendment filings to disclose changes in insiders’ holdings, etc. These tactics are designed to make the firm look as attractive as possible before IPO, perhaps more attractive that it actually is. Thus, data about pre-IPO firms is less reliable than is data about post-IPO firms is.

For individual investors looking for long-run returns, IPOs may not be the best strategy. A pretty consistent research finding is that IPOs underperform the market in the years following IPO. This underperformance is due to several factors, including the (a) the difficulty of meeting the demands of public trading (e.g., establishing and meeting quarterly earnings targets, creating the structure necessary to meet reporting requirements, etc.), (b) overvaluation around the time of the IPO, (c) changes in managers’ incentives following IPO, (d) liabilities of smallness and newness relative to competitors, and (e) insiders unloading shares after the lockup period, etc. Thus, on average, other stocks may be better investments than IPOs are.

If a person buys IPOs in the open market, the most profitable short-term strategy is probably to flip the shares in the days following IPO. Brokerage firms frown upon such flipping, because it creates price volatility, uncertainty, and might serve as a negative signal. Although institutional investors engage in flipping regularly and profitably, brokerage firms usually discourage this practice in individual investors (the latter are usually less powerful and may be chastened or sanctioned by brokerage firms).

Most IPO shares are targeted to institutional investors. Underwriters have an interest in allocating shares to these investors first (e.g., to court a market for future IPOs). Few remain for individual investors. Those that do are either (a) tied to weaker stocks or (b) allocated to individual investors with larger accounts who trade more frequently (because they are more profitable customers). Occasionally, firms issue equity shares to individual investors, but those shares are often laden with terms that prevent the investors from selling the shares for months (or longer). These opportunities vary by IPO, so individual investors interested in such shares should check with the major underwriters handling each particular offering. Of course, once the stock begins trading, individual investors can purchase the stock like any other stock.

Belinda Mucklow

Senior Lecturer in Finance with the University of Wisconsin School of Business
Belinda Mucklow
Twitter

Twitter is going to great lengths to avoid the missteps made by Facebook - among which is choosing a different lead underwriter. FB's stock price tanked in the first year and has only surpassed its IPO price in August this year. Twitter has yet to actually set its final IPO price. Estimates of the fair value of shares range from $17.50 per share up to $50 per share. Shares prices always reflect expectations as to the future; the highest prices reflect some very optimistic expectations as to the future.

If I had to guess, I would say at an IPO price of $20 there will be a decent rise in the price in the first day of trading. However, there will massive interest in financials to see if revenue growth is on track and failure to live up to expectations could result in large price changes. So if you are a value investor and like to sleep at night, you probably won't want to pay more than $20-$25. I doubt Warren Buffett is going to be rushing in to buy this stock.

Potbelly

Potbelly's price went up to $33.90 immediately after IPO and has since dropped back somewhat to $25.84. It is now trading at higher multiples than most of its peers, which suggests that it is not undervalued given that its same store sales (comps) are on the low end. Stated another way, higher multiples mean you are paying more for the stock per unit of income than for a company with lower multiples and can be justified if you think the company is going to grow at a faster rate than its peers or improve its profitability in the future. The same store sales measures increase in sales at a store (rather than increases in sales by opening more outlets) and is the measure to focus on to get a feel for growth. For the first half of 2013 the SSS were 1.7% for Potbelly, which was lower than Panera or Chipotle.

Playing the IPO Market

Small investors are unlikely to be able to get in on an IPO. They will, of course, be able to trade in the secondary market after the IPO. If you are a small investor and someone offered to let you in on an IPO you should be very wary as any IPO worth its salt will be in heavy demand and likely allocated to the largest clients of the underwriters. I tell my students it is like Groucho Marx's quote "I don't want to belong to any club that would have me as a member". If as a small investor you can get in on an IPO then it is probably a stock you don't want to own!

Sometimes the company being underwritten will make sure that some shares get directed to the state in which company is headquartered, or more rarely to its customers.

Keith Jakob

Donald and Carol Jean Byrnes Professor of Finance in the University of Montana’s School of Business Administration
Keith Jakob
Twitter

Twitter is bucking the recent IPO trend somewhat. In the 1990’s it was not uncommon for firms to go public on expectations – even if they had no earnings. Today, most firms wait until they have demonstrated some profitability before they reach the IPO stage. Twitter will go public having reported losses in its most recent quarter.

In our opinion, the twitter IPO really depends on your thoughts about whether Twitter can do two things: First they need to continue to grow the number of users, and second they need to successfully monetize the eyeballs. Perhaps we are too old for Twitter, but we find it hard to believe that user growth will continue to grow as quickly, and monetization of Tweets will be difficult compared to other forms of internet based communication.

Potbelly

Potbelly Sandwich Shop PBPB is a chain of eateries in a very competitive and crowded market. The stock had an incredible pop of over 100% on the IPO day, but has been falling steadily since. The stock has a 180 day lockup period, which means company insiders or those holding majority stakes in the firm are forbidden to sell any shares until April 2014. More than half of the $94 million net proceeds from this offering were used to pay a dividend to the pre-IPO common and preferred shareholders.

Around $43 million of this went to executives, directors of the firm, and large pre-IPO shareholders. As with most IPOs, the valuation story for Potbelly is about growth. If the company is successful in growing beyond its current markets, it could turn out the current valuations for PBPB are accurate or even low. However, we believe that at current valuations, the company is priced to perfection.

Any hint of a 'blip' in growth could lead to major revisions. We do not expect a lot of growth in the company’s stock price anytime soon (but we could be wrong).

Active 2013 IPO Market

It is clear historically that the number of IPOs in a year is correlated to the direction of the stock market. So whether there have been “many” IPOs in 2013 (or not) is somewhat relative. For example, during the 1990s, The DJIA rose from 2,590.54 to 11,497.12 and there were on average 409 IPOs per year. From 2000 to 2009 the DJIA fell to 10,428.05 and the average IPOs per year fell to under 140.

In 2012, there were approximately 150 IPOs in the U.S. Through 9 months, there have been approximately 150 in 2013, with projections that the total number of IPOs could reach 200 by year end. It is true that this represents a significant increase in IPO activity as compared to 2008 and 2009 when there were less than 50 IPOs per year, but it is still well below the levels of the 1990’s. What has fueled the growth in IPOs recently is a stronger U.S. Stock market. The DJIA is up 18.5% on the year.

Rising stock markets are fueled by demand for stocks. This increase in demand creates an opportune time to go public. For a company planning an IPO, a “hot” market means a higher valuation for the company’s shares, which leads to greater IPO proceeds for the issuing company or its selling shareholders. For the investment banker “underwriters” of IPOs, a strong market means a stronger market reception for IPO shares – reducing the banks issue risk.

IPO performance is generally broken into two categories: the first day “pop,” and more long-term performance. Year to date the average first day pop for IPOs is right around 16%. Whether you think this is good or bad really depends on your benchmark. The average level of IPO underpricing for any given year tends to move up and down along with the number and magnitude of the issues in the year. In 1999 the mean first day return was 70.9% and there were 477 IPOs with gross proceeds of nearly $65 Billion. After the dotcom bust in 2002 there were only 66 issues with $22 Billion in proceeds and first day returns fell to around 9%. While not all IPOs enjoy a first day pop (witness Facebook last year) on average about 75% of all IPOs experience a first day increase in price. As for long-term performance, most academic literature suggests that IPO firms on average actually underperform for the next several years after the IPO.

Playing the IPO Market

As you can see from the data, choosing IPOs is probably less about the firm characteristics of the IPO and more about timing your IPO purchases to when the IPO market is favorable. It is important to remember that the underpricing discussed is average under-pricing. For the vast majority of IPOs in the U.S. the retail syndicate controlling the initial sale of shares has discretion as to how those shares are allocated. This creates an opportunity for brokerage units to allocate those shares to its “preferred” customers first. When demand for an IPO is high, there may be little or no shares available for the average investor. This leads to a potential “winners curse,” as average investors are likely to get bigger allocations of low demand IPOs and small or no allocation from high demand IPOs.

Our suggested strategy would be to invest less in the IPOs that appear to be easy to obtain. As a quick glance of most IPO proxy statements will reveal, big brokerage houses are allocated more IPO shares than smaller brokerages and therefore may be better able to assist you in obtaining shares in IPOs. As an example, Fidelity has active relationships with Deutsche Bank, Kohlberg Kravis Roberts & Co. (KKR) and multiple other underwriters to offer access to both new issue equity and fixed income offerings. Still, to participate through Fidelity for IPOs from Deutsche Bank a brokerage customer.

Has to have a minimum of $500,000 in certain assets held at Fidelity. Another alternative for smaller investors is to invest in an IPO mutual fund such as IPOSX from Renaissance Capital. Funds like these come with their own set of trade-offs. A fund like this will give a small investor better access to IPOs, but the gross expense ratio is very large!

Tony Crawford

Associate Professor of Finance in the University of Montana’s School of Business Administration
Tony Crawford
Twitter

Twitter is bucking the recent IPO trend somewhat. In the 1990’s it was not uncommon for firms to go public on expectations – even if they had no earnings. Today, most firms wait until they have demonstrated some profitability before they reach the IPO stage. Twitter will go public having reported losses in its most recent quarter.

In our opinion, the twitter IPO really depends on your thoughts about whether Twitter can do two things: First they need to continue to grow the number of users, and second they need to successfully monetize the eyeballs. Perhaps we are too old for Twitter, but we find it hard to believe that user growth will continue to grow as quickly, and monetization of Tweets will be difficult compared to other forms of internet based communication.

Potbelly

Potbelly Sandwich Shop PBPB is a chain of eateries in a very competitive and crowded market. The stock had an incredible pop of over 100% on the IPO day, but has been falling steadily since. The stock has a 180 day lockup period, which means company insiders or those holding majority stakes in the firm are forbidden to sell any shares until April 2014. More than half of the $94 million net proceeds from this offering were used to pay a dividend to the pre-IPO common and preferred shareholders.

Around $43 million of this went to executives, directors of the firm, and large pre-IPO shareholders. As with most IPOs, the valuation story for Potbelly is about growth. If the company is successful in growing beyond its current markets, it could turn out the current valuations for PBPB are accurate or even low. However, we believe that at current valuations, the company is priced to perfection.

Any hint of a 'blip' in growth could lead to major revisions. We do not expect a lot of growth in the company’s stock price anytime soon (but we could be wrong).

Active 2013 IPO Market

It is clear historically that the number of IPOs in a year is correlated to the direction of the stock market. So whether there have been “many” IPOs in 2013 (or not) is somewhat relative. For example, during the 1990s, The DJIA rose from 2,590.54 to 11,497.12 and there were on average 409 IPOs per year. From 2000 to 2009 the DJIA fell to 10,428.05 and the average IPOs per year fell to under 140.

In 2012, there were approximately 150 IPOs in the U.S. Through 9 months, there have been approximately 150 in 2013, with projections that the total number of IPOs could reach 200 by year end. It is true that this represents a significant increase in IPO activity as compared to 2008 and 2009 when there were less than 50 IPOs per year, but it is still well below the levels of the 1990’s. What has fueled the growth in IPOs recently is a stronger U.S. Stock market. The DJIA is up 18.5% on the year.

Rising stock markets are fueled by demand for stocks. This increase in demand creates an opportune time to go public. For a company planning an IPO, a “hot” market means a higher valuation for the company’s shares, which leads to greater IPO proceeds for the issuing company or its selling shareholders. For the investment banker “underwriters” of IPOs, a strong market means a stronger market reception for IPO shares – reducing the banks issue risk.

IPO performance is generally broken into two categories: the first day “pop,” and more long-term performance. Year to date the average first day pop for IPOs is right around 16%. Whether you think this is good or bad really depends on your benchmark. The average level of IPO underpricing for any given year tends to move up and down along with the number and magnitude of the issues in the year. In 1999 the mean first day return was 70.9% and there were 477 IPOs with gross proceeds of nearly $65 Billion. After the dotcom bust in 2002 there were only 66 issues with $22 Billion in proceeds and first day returns fell to around 9%. While not all IPOs enjoy a first day pop (witness Facebook last year) on average about 75% of all IPOs experience a first day increase in price. As for long-term performance, most academic literature suggests that IPO firms on average actually underperform for the next several years after the IPO.

Playing the IPO Market

As you can see from the data, choosing IPOs is probably less about the firm characteristics of the IPO and more about timing your IPO purchases to when the IPO market is favorable. It is important to remember that the underpricing discussed is average under-pricing. For the vast majority of IPOs in the U.S. the retail syndicate controlling the initial sale of shares has discretion as to how those shares are allocated. This creates an opportunity for brokerage units to allocate those shares to its “preferred” customers first. When demand for an IPO is high, there may be little or no shares available for the average investor. This leads to a potential “winners curse,” as average investors are likely to get bigger allocations of low demand IPOs and small or no allocation from high demand IPOs.

Our suggested strategy would be to invest less in the IPOs that appear to be easy to obtain. As a quick glance of most IPO proxy statements will reveal, big brokerage houses are allocated more IPO shares than smaller brokerages and therefore may be better able to assist you in obtaining shares in IPOs. As an example, Fidelity has active relationships with Deutsche Bank, Kohlberg Kravis Roberts & Co. (KKR) and multiple other underwriters to offer access to both new issue equity and fixed income offerings. Still, to participate through Fidelity for IPOs from Deutsche Bank a brokerage customer.

Has to have a minimum of $500,000 in certain assets held at Fidelity. Another alternative for smaller investors is to invest in an IPO mutual fund such as IPOSX from Renaissance Capital. Funds like these come with their own set of trade-offs. A fund like this will give a small investor better access to IPOs, but the gross expense ratio is very large!

Gerard Hoberg

Associate Professor of Finance in the Robert H. Smith School of Business at the University of Maryland
Gerard Hoberg
Potbelly

I view Potbelly as a safer bet [than Twitter] as far as the business model and being a Potbelly customer, I have faith in the business model and the firm's likely success. So it comes down to pricing. After the tremendous returns, history would suggest that the future returns over the coming months will likely be modest as the market has not priced the issue. I don't think it will experience additional major gains or losses until we see a couple quarters of earnings results, which will allow us to track its growth more accurately.

Active 2013 IPO Market

Despite the gloomy headlines in the press about government budgets and war abroad, the market is near all-time highs. The stronger the stock market performs, the more IPOs we expect to see. A strong stock market provides a high level of liquidity and demand for equity, making the "IPO window" very much open. Many firms wait until the market is receptive and then IPO, so it is common to see IPO clusters in some markets.

As far as how they have done, I can only speculate some as I have not done a statistical analysis of all of the IPOs. But my take is that there is much volatility around the initial pricings, but on average they might have been fair investments. I am not sure how long you want to go back, but comparing Facebook and Potbelly is a great example. If you bought both and held for brief time, you would have one winner and one loser, but the volatility is eye popping. This indicates that there is a degree of disagreement among investors regarding what these firms are worth. This relates to some degree of uniqueness and the absence of true comps for pricing.

Playing the IPO Market

History suggests that the best way to play IPOs is to buy at the IPO price if at all possible, and to be cautious regarding buying in the stock market after the IPO is already out. It is well known that buying at the IPO on average generates a quick 10-15% profit on the shares that could be realized if one sells on the market in the first day. So you get a discount by buying direct. But the problem is that shares are often very hard to get, and you would have to have a brokerage account with one of the managing underwriters. For example, if you have a Fidelity or an E-Trade account, it may be hard to get the shares. But if you have a Goldman Account (and are wealthy), it is easier to get shares given that Goldman is doing very well in getting into the IPOs as an underwriter.

Buying on the stock market after the IPO is more expensive, but the track record is not good or bad. In recent times, these investments are about average in terms of returns, but they are volatile. I would recommend only buying firms after doing some quantitative analysis of the pricing relative to the expectations for the firms future. There are profits to be made if one is careful and has a strong business sense for the future of these firms, but most investors do not have this kind of edge and would do better buying a diversified index.

Timothy Loughran

C.R. Smith Professor of Finance in the Mendoza College of Business at the University of Notre Dame
Timothy Loughran
Twitter

There is a lot to like about Twitter. The firm has a fantastic product being used by more than 215 million people each month. However, even with huge growth in sales, Twitter still has negative operating earnings.

Potbelly

Potbelly is in a very competitive market. There are no significant barriers to entry to the restaurant sector. As Potbelly notes in the Risk Section of their IPO prospectus, “we face significant competition for customers.” Given that Potbelly has only 286 shops, the firm clearly has more room to grow.

Active 2013 IPO Market

This has been a good year for IPO volume for two reasons. First, the S&P 500 Index is near all-time record highs. High levels of the stock market have typically been associated with high IPO volume. The two go hand in hand. Second, 2013 has been a solid year for IPOs because 2008-2012 were very poor years in terms of IPO volume. The scarcity of IPOs during the last five years has created a bit of an IPO backlog. Some 2013 IPOs might have gone public in 2010 or 2011 if market conditions were better. Although 2013 is going to have strong IPO volume compared to the last five years, recall that 676 IPOs went public back in 1996. We are quite far from having that type of IPO volume anytime soon.

Playing the IPO Market

The first step for investors should be to look over the IPO prospectus on EDGAR. Understanding the IPO’s business model is critical for success. Since many IPOs have never produced positive earnings, it is important to properly evaluate the chances of the IPO eventually becoming profitable. For firms like Potbelly or Sprouts Famers Market, it might be helpful if investors visited local stores to gauge employee morale and try out their products/services.

Amiyatosh Purnanandamam

Michael R. and Mary Kay Hallman Fellow in the Ross School of Business at the University of Michigan
Amiyatosh Purnanandamam
Twitter

TWTR looks like a very high growth, but a loss-making company as of now. As an individual investor, I will stay away from it.

Potbelly

I find PotBelly's (PBPB) valuation to be too high given its earnings. I will stay away from it based on my golden rule of profitably based investing.

Active 2013 IPO Market

The number of IPOs correlate very well with the overall market conditions. IPOs come in waves: when market valuations are high, you see more IPOs. In hot markets, issuers are typically able to get higher valuation for their firm. Hence, incentives to go public is higher.

Playing the IPO Market

In general, individual investors should be very cautious about investing in IPOs. First, they are unlikely to get allocation in the primary market. Said differently, individual investors are unlikely to get IPOs at the offer price. Institutional investors get that as part of the underwriter's book-building process.

But if you want to invest in it, I would recommend looking at fundamentals of the company. Look at earnings and beware of "excessive growth.” In my research, I show that IPOs with good earnings do better in long run. Growth IPOs are more risky. A good combination will be to look for IPOs with good earnings and moderate growth. I would caution against investing in IPOs with very high growth but little or no earnings.

James C. Brau

Professor of Finance in the Marriott School of Business at Brigham Young University
James C. Brau
Active 2013 IPO Market

Twitter looks a lot like the IPOs that went public during the .com boom. They had revenues, but negative earnings. It seems the more users Twitter gets, the more money they lose. I would be a bit wary, as an investor, and try to make sure Twitter isn’t going to be like one of the .com IPOs which had splashy IPOs and then could never turn a profit.
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John Kiernan is Senior Writer & Editor at Evolution Finance. He graduated from the University of Maryland with a BA in Journalism, a minor in Sport Commerce & Culture,…
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