Why You Should Stay Away From Tech IPOs

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In this video from Motley Fool Answers, Alison Southwick and Robert Brokamp welcome Dylan Lewis, host of Industry Focus: Tech, to the show for his take on IPO investing -- and the relatively abysmal performance of tech stocks in the months after their debut.

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A full transcript follows the video.

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This video was recorded on June 27, 2017.

Alison Southwick: The next thing that you need to know before you invest in tech stocks is IPO, more like IP no!

Dylan Lewis: Oh, groan.

Robert Brokamp: That was a good one!

Southwick: Oh, that stinks. These are the jokes, kids. So tech is known for high-flying IPOs.

Lewis: Absolutely. Very often, tech companies are pretty highly followed before they even go public. You know, you have that class of unicorn companies, start-ups that have been around and grown into these massive valuations. Part of that is just that they're companies that we use all the time. Like Airbnb is something that we're super familiar with. Lyft. Uber. These are all companies that we know very well and they're kind of consumer facing.

It's exciting being on the editorial side and being on the coverage side of this that there's so much fanfare and investor interest around these companies. I think something that people need to be aware of, though, is it's not necessarily great to buy into these IPOs immediately after they're available. Really, in recent history, a lot of tech IPOs have not performed all that well. So my guidance -- and we can run through some companies that back this up -- is to wait maybe six to 12 months after an issuance before seriously considering buying into it.

Looking at three of the biggest tech IPOs from 2016, you have LINE Corp., Nutanix, and Twilio, and none of these companies are currently trading above where they ended their first day on the public markets. As a reminder, the S&P 500 is up since every one of their issuances. So the broad market has done fairly well. Like I said, we've been in a bull market for quite some time now, and yet all of these companies are down.

Some of that is there's this pent-up demand for these companies when they go public, so shares get bid up to these extreme valuations and then they have to come back down to reality a little bit, as the business posts quarterly results and management provides commentary.

One of the reasons that I say people should probably wait six months -- maybe 12 months -- is really because ultimately the company decides when it's going public, and I think that's an important thing to remember. So management is choosing when they are selling shares, and they're going to do it at a time when the business results look pretty good. They want to be able to command top dollar for part ownership of this business. At the end of the day, an IPO is a capital-raising event, so they're doing a service to their own company by raising capital at the highest valuation they can. It gives them more cash to work with. So there's that side of it.

I think you also want to just have a couple of quarters of numbers to look at. And if you start seeing a troubling trend in the prospectus that the company files, you might want a couple of more quarters of updates before you decide that margins are going to stay where they are, or user growth is going to continue and that was just a minor blip. And so just waiting a little while and letting them weather the first couple of months of being a publicly traded company and the scrutiny that comes with that can give you that insight.

Southwick: Ideally, here at The Motley Fool, we believe in holding stocks for three, five, 10 years. Forever. So what's a few months, really, in the grand scheme of things?

Lewis: I mentioned that Facebook has been such a great stock to own, but Facebook largely foundered for the first year that it was a publicly traded company, and it wasn't until a little bit more than a year out from its IPO that the business results really started to back up its valuation and investors saw things take off. So even a wildly successful company follows this rule.

Brokamp: The guy who I think is most known for research on IPOs is a professor named Jay Ritter at the University of Florida, and if I'm recalling correctly, it's pretty clear that for the three-year holding period after a company goes public, on average an IPO will underperform the market. It's generally better to wait to see what's going to happen to the company.

Alison Southwick has no position in any of the stocks mentioned. Dylan Lewis owns shares of Facebook. Robert Brokamp, CFP owns shares of Facebook. The Motley Fool owns shares of and recommends Facebook. The Motley Fool recommends Twilio. The Motley Fool has a disclosure policy.