Not Every IPO Has a Silver Lining

Tim Melvin  |

On Thursday, investors saw the debut offering of Twitter  (TWTR) and to put it mildly, it was well received.

The stock appreciated more than 70 percent on its first day of trading. As impressive as that is, it is behind an offering like the Container Store  (TCS) and Noodles & Co.  (NDLS) that actually doubled in the first day of trading.

It has been a hot IPO market so far this year with the pace of offering up about 60 percent year over year in the second quarter and a strong first day performance of most of these deals at about 17 percent according to Renaissance Capital, an IPO research firm. That is the highest average first day return in over a decade as investors have embraced the IPO market with a passion.

Given all the excitement and incredible returns surrounding the IPO market, should investors be jumping on the bandwagon?

The truth is that if you could get shares in the hot deals, it would probably be a worthwhile exercise to buy the hot offering and sell them very quickly into the aftermarket.

The problem lies in the fact that in all likelihood, investors cannot get an allocation of shares in a popular deal. These shares are saved for institutions and even some select individuals that pay an enormous amount of commissions and fees to their brokers. Most individuals are left with the option of buying them in the aftermarket.

That's exactly the wrong thing to do, according to the data collected by Jay Ritter, a professor at the University of Florida. He looked at IPO returns minus the first day return and found they badly lagged the overall market and similar size firms. He looked at the average three year buy-and-hold return from buying IPO companies after the first day of trading and found they badly lagged the stock market.

On average, the IPOs trailed the broader market by almost 20 percent over the three year period.

The average first day gain was about 17 percent, so investors who got the first day gains did okay, but aftermarket buyers would have been better off in an index fund.

If you have a great relationship with your broker and can often gain access to IPOs, it probably makes a lot sense to play the IPO game. If the shares go up right away pocket the money by selling as soon as you can. Of course many IPOs have a penalty bid and if you sell too soon, the broker has to give back part or all of his commissions. In the end, the broker will not be very happy with you and that could negatively impact your ability to get future offerings so most of the time individuals will need to hold through the penalty period to play the IPO game.

If a broker ever calls and offers you IPO shares, it is best to politely decline. If they have shares available to sell rather than use as a reward for big commission clients, the deal is most likely a bust and will fall shortly after the deal closes.

As exciting and profitable as buying IPO issues can be it is a game most of us will not be able to play on a regular basis.

Chasing shares in the aftermarket after a first day pop has proven to be a loser's game and can lead to long term underperformance. When traders engage in this activity, all they are doing for the most part is providing liquidity for the institutions that got an allocation to sell their stock at a profit.

If traders do not get an allocation of shares in the offering, they are usually better off to step aside and wait for the excitement to settle down and evaluate the stock on its merits as a candidate for purchase.

IPOs will get a lot of headlines and news chatter, but they do not really play the big a role in our activities as long term investors. After the first day price movement they tend to underperform the market and often these stocks will show up in the bargain bin after a year or two and may be a better investment opportunity at that time.

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DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to:

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