MARKET COMMENTARY

The IPO Market Heats Up: How to Avoid Getting Burned

05.16.2019 - Carin L. Pai, CFA

The IPO market gained traction in 2018, heated up in early 2019, and is now accelerating at a pace that could result in a record-breaking year for initial public offerings.

While there are attractive opportunities out there for savvy investors, our advice is to approach the IPO market with caution. With strong demand for new issues and valuations that are generally rich, the risk of overpaying for a stock with less-than-impressive fundamentals is high.  

In addition, history shows that companies typically underperform the market for many years after going public. So, investors who are attracted to this sudden frenzy of IPO activity should keep this in mind when thinking about their time horizons. You may have to remain patient if you expect to earn an attractive return on your investment.

Catalysts: Late-Cycle Growth Sparks an IPO Resurgence

We see three main catalysts for this recent surge in IPOs:

First, IPO activity tends to accelerate when stakeholders believe the market cycle is approaching a peak because private companies and venture capital investors see an opportunity to capitalize on high valuations and cash out of their investments. Since US stock prices have been climbing for more than a decade, and the US economy and financial markets appear to be approaching the late stages of a slow and steady growth cycle, many startups are sensing that now is the time to go public before the markets and economy cool down.

Second, bouts of market turbulence like the December correction are reminders that low volatility may not last forever. So, companies that have been thinking of raising capital in public markets are taking advantage of market conditions to capture the opportunity while risk appetites are healthy.  

Finally, companies are concerned that the Fed’s efforts to normalize interest rates could cause sources of private capital investments to dry up. Although the Fed is on hold, it seems clear that rates are unlikely to fall by any meaningful degree any time soon, and that the peak of market liquidity appears to be behind us. In the past decade, access to liquidity and capital has been plentiful, which has kept the private equity and venture capital markets buoyant.

In total, private investments increased almost 58% in 2018, the tenth consecutive year in which the value of private investments exceeded the value of IPO investments. Technology and biotech companies were the primary beneficiaries, receiving a combined $130.9 billion from private investors, versus $50.3 billion from IPOs and follow-on offerings.

This trend continues in 2019, with venture capital far outpacing public-market fundraising.

A Historical Perspective: More Activity, Higher Valuations

If stock prices continue to follow an upward path and IPO activity ramps up as expected, it is possible that the total value of initial public offerings this year could break the record set in 1999, when 547 companies raised a record $107.9 billion in IPOs.

This resurgence began last year, when there were a total of 176 IPOs that raised a combined $48 billion. The IT and Health Care sectors represented roughly 70% of that activity. Last year was also the biggest year for tech IPOs since the 2008 global financial crisis sent a chill through the IPO market.

In addition, companies are generally remaining private much longer than they have in the past, encouraged by a high-liquidity environment (low interest rates and rising stock market valuations) that has made it easier to access capital from private sources. As a result, they are growing faster by staying private and coming to market with higher market capitalizations.


Companies Are Staying Private Longer, Raising More Capital
Median number of years before IPO and amount of capital raised prior to IPO

 

Source: Wilmerhale IPO Report 2018. Underlying data from Dow Jones VentureSource and SEC filings.

Return on Capital: Patience May Be Required

While market capitalizations for tech companies going public have been rising, returns have been shrinking. If you invested $100 in Amazon stock when it went public in 1997, for example, it would be worth approximately $67,400 today (674 times your investment). But $100 invested in Facebook’s IPO in 2012 would be worth just $400 today (four times your initial investment).

Market Caps for Tech Firms Have Increased, but Returns Have Weakened
Market capitalization at IPO and investor returns as of April 2019

Source: S&P Capital IQ.

One of the primary risks faced by IPO investors is that, on average, companies (tech and non-tech) tend to underperform the market during the first five years of public ownership.

Stocks Tend to Underperform in the First Five Years of Public Ownership
Returns compared to companies of similar size and book-to-market ratios

Source: Initial Public Offerings: Updated Statistics
Jay R. Ritter, Cordell Professor of Finance, University of Florida, December 31, 2018

In many cases, even with some highly anticipated IPOs such as Lyft and UBER, which just came to market, we expect it to take many years before they reach profitability as their business models continue to evolve. Based on the lofty valuations we are seeing for these companies, investors have high expectations for their future growth prospects.

While it is not unusual for companies to go public even though they have no earnings or significant operating losses, this number has been increasing in recent years.

More Companies Without Earnings Are Going Public
81% of stocks that went public last year had negative earnings

Source: Initial Public Offerings: Updated Statistics
Jay R. Ritter, Cordell Professor of Finance, University of Florida, December 31, 2018

For all of these reasons, we believe the balance of risk and potential returns in today’s IPO market tilts more heavily toward risks. Therefore, we have been patiently watching IPO activity from the sidelines. If and when the risk/reward tradeoff improves, we will consider becoming active participants.

Still, there is no question that investor appetite for newly issued tech stocks is strong. In fact, a new breed of “technology-enabled” companies is well-represented among the IPOs scheduled in 2019 (e.g. Uber, Lyft, Pinterest, etc.). In our view, this development is a clear indication that technological innovation is migrating into other areas of the market; transforming non-IT sectors, industries and areas of the economy in significant ways.

The Public Securities Market is Shrinking

One more reason to be highly selective in this environment is that the universe of publicly traded securities has been shrinking consistently. Although the total combined number of private and public US firms grew by 10% from 1997 to 2016, the number of publicly traded firms was cut in half.

As discussed, an ample supply of private capital has been flowing into private firms and delaying public offerings. In addition, low interest rates have also sparked a flurry of corporate share buybacks—further chipping away at the number of securities traded on public markets.

Our Advice: Approach IPOs With Extreme Caution

When we consider all these factors together—strong demand, limited supply of growth companies, high valuations and long return horizons—it seems clear to us that the best way to avoid getting burned in this hot IPO market is to avoid the hype, focus on fundamentals and always remain cool, calm and collected.


Publicly Traded Companies Represent a Smaller Portion of the Universe

The total number of firms grew by 10% from 1997 to 2016, but publicly traded firms fell by 50%


NBER Working Paper 24265, January 2018. Underlying data from The Center for Research in Security Prices (CRSP).


This communication is intended solely to provide general information. The information and opinions stated are as of May 9, 2019 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.

MARKET COMMENTARY

Asset Allocation Update: Fundamentals Have Been Slightly Better Than Expected, Despite Lingering Trade Tensions

06.20.2019 Viraj B. Patel, CFA, FRM, CAIA

NEXT POST

MARKET COMMENTARY

Unusual Economic Conditions Keep the Yield Curve Flat

04.17.2019 Jeffrey S. MacDonald, CFA

PREVIOUS POST