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

Wall 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.