Many investors get excited about the prospect of buying stock in a company that becomes available for the first time on the public market, an IPO. It could be new technology or a new product or service that excites them, but the goal is always the same; make a killing by being one of the first investors in. Unfortunately, most IPOs don’t fare particularly well over time (especially after the first day of trading). Here are three reasons why Clearview does not invest in IPOs for its clients.
- We buy shares in companies that are seasoned; those that have proven themselves over time. We look for a modest debt load and consistent sales and earnings growth over multiple economic cycles. Consistent (and robust) dividend growth is a must for stocks in our Dividend Growth strategy. Most companies we select are number one or two in their industries. These types of companies are also better able to weather a recession because they have done it before. Most IPOs are untested over a full economic cycle and are far from seasoned or proven.
- We abide by strict valuation metrics which usually disqualifies IPOs. Valuation tools that we use are traditional and very discriminating. For example, price to earnings ratios, price to sales ratios, cash flow multiples, and dividend yields are carefully scrutinized for each new and existing investment. However, IPOs are often priced (valued) as a multiple of sales because there are no current earnings. In fact, profits may not be earned for many years. Although current valuations on IPOs are still too high for us, they are not as crazy as they were in the 1990s. Some IPO valuations were partly based on the number of viewers a website received in the dot.com era!
- The investment track record of IPOs is dismal. After all, you are buying shares from the smart money, those who know the company inside and out. If these insiders are selling, why do others want to be buyers? Of course there have been big IPO winners over time (Microsoft, Google, and Amazon to name a few), but the overall record is inconsistent and spotty. For example, the median performance of the 15 biggest IPOs is 4.1% in their first year after the first day’s close. A significant number of IPOs lose money for their investors. Facebook was down 50% after six months (it has since recovered). Three of the “could not miss” IPOs from the dot.com bubble – Pets.com, Webvan, and etoys.com – went bankrupt within two years. More recently, Groupon is down 73% and Angie’s List is down 56% since coming public. Finally, the biggest IPO of all time, Alibaba, rose 38% on day one, but since has come under pressure. It is now down 14% from its all-time intra-day high.
It is hard for us to get excited about investing in IPOs, especially after we take into account the risks taken with an unproven company at unreasonable valuation levels. Instead, disciplined investors should stay true to their style and not be seduced by the allure of easy money. There are many successful money management styles practiced by professionals, but very few of these include IPOs as key to their success.