Initial public offerings (IPOs) are supposed to represent the Holy Grail. It's your chance to own the next Microsoft or the next Google. But is it really your lottery ticket to riches?
Here's what usually happens: People buy stocks at the wrong price hoping for a quick gain and more frequently end up with quick losses.
Social media stocks are 2012's poster child for what can go wrong. Overhyped IPOs like Facebook (NasdaqGS:FB), Zynga (NasdaqGS:ZNGA), and Groupon (NasdaqGS:GRPN) were promoted as a sure thing. Since its May debut, Facebook has already lost more than half its value and Zynga around $2.50 per share is now a penny stock. (Unlike Wall Street's spin doctors, the ETF Profit Strategy Newsletter warned its readers to avoid Facebook before it went IPO.) As a group, social media stocks (SOCL) have only gained 2.41%, which lags the broader stock market (VTI) by very wide 12% margin.
Does that mean IPOs are a bad investment? Not necessarily.
Since 1980, the average first day return for IPOs has been 18%. But here's the problem: Those returns are based upon buying the IPO at the stock's offer price and selling it on the first closing day. Most investors can't buy IPOs at the offer price, because only the underwriters' favorite clients are given that chance. Instead, investors have to buy the IPO in the public market, usually after its price has already "popped."
Does buying and holding an IPO improve your odds of making a profit? Not necessarily.
The chart below shows that more than 50% of the IPOs over the past three years lost money during the first three and six months of trading. Here's another fact: The odds of losing a large amount of money (more than 10%) jumped in moving from 3 to 6-month holding periods. This could be due to the lock up period, which is generally between 90 and 180 days when company insiders are restricted from selling their shares. After the lock-up period expires, downward pressure on the stock can follow. (VIDEO: Facebook IPO Burns Investors.)
For longer-term investors, here's more sobering numbers: The 3-year buy-and-hold returns for IPO stocks lagged the average 3-year cumulative returns of similar non-IPO stocks by 7.4% from 1980 through 2011, according to data from Professor Jay Ritter of the University of Florida. His research also showed that, from 1970 to 2010, IPOs have underperformed similar non-IPO stocks by an average of 1.8% per year during the first five years after issuance.
Interestingly, there have been some disconnects with the intermediate performance (5-years) of IPOs easily beating the broader stock market.
Over the past five years, the First Trust U.S. IPO Index ETF (FPX) has gained 14.60% compared to a 6.52% loss for the S&P 500 (SPY). FPX's index includes the 100 largest and most liquid U.S. IPOs. Holdings are given a 10% cap and holdings are rebalanced quarterly. FPX's annual expense ratio is 0.60%.
This year's lackluster performance of social media IPOs isn't good and neither are the shelved plans for upcoming IPOs like Dave & Buster's, Fender Musical Instruments, and MobiTV. With major stock indexes near their all-time highs, it's quite suspicious that IPOs are being delayed. "Unfavorable market conditions" are the typical excuse given for halting an IPO.
In summary, unless you're a corporate insider or an underwriter, IPO investing isn't a get-rich quick strategy. For every LinkedIn (LNKD) or Google, there's an ocean of losers.
Follow us on Twitter @ ETFguide