FINANCIAL MARKET UPDATE 12.15.2020

AUTHOR: JOSH JENKINS, CFA

STORY OF THE WEEK

IPOS APPROACH RECORD VOLUME IN 2020

The volume of Initial Public Offerings (IPOs) is within striking distance of a record in 2020. Recently, investors have been willing to open their wallets for any stock offering growth as the global pandemic continues to weigh on the economy. The generous prices being paid on stocks in general and new issues, in particular, have enticed many private companies to go public. Although some of these newly public companies have seen their share prices spike on their first day of trading, IPOs have historically been a poor investment for individual investors.

With the exception of 2014, when Alibaba became the largest-ever U.S. listed IPO, 2020 has already seen the largest dollar volume of IPOs since the peak of the Tech Bubble (1999/2000). The high volume of deals isn’t the only reason to draw comparisons with that period. Frothy investor sentiment, sky-high valuations, and a concentration within the technology sector offer additional similarities. While market exuberance doesn’t appear to have fully reached tech bubble levels, as the chart below illustrates, these characteristics typically do not signal strong returns ahead. 

 

Note: Price-to-sales ratio based on trailing 12 months revenue before IPO, measured after first day of trading. Source: WSJ & Jay Ritter, University of Florida

Speaking of tech companies going public, last week saw the much-anticipated IPOs of Airbnb and DoorDash. Each company saw its share price roughly double during the first day of trading. Nothing sparks demand for new share issuance like watching other people double their money in a single day. Unfortunately, investors looking to get in on the action and capitalize on the next big IPO may be disappointed.

Studies, like the one from Dimensional Fund Advisors (DFA) below, have shown that the performance of IPOs has historically lagged the broader stock market. As the table illustrates, both the Russell 3000 (a proxy for the domestic stock market) and the Russell 2000 (small-cap stocks) have handily outperformed IPO stocks(1) during the full period from 1992 to 2018, and they did so with a fraction of the volatility.

Source: Dimensional using Bloomberg data. The sample includes US market IPOs, including US-domiciled companies and foreign-domiciled IPOs in the US, with an offering date between January 1, 1991, and December 31, 2018. IPOs with an offer price below $5, unit offers, REITs, closed-end funds, ADRs, partnerships, and acquisition companies are excluded. The hypothetical IPO portfolio is formed December 31, 1991, and rebalanced monthly to include all firms with an initial public offering during the prior 12-month period. Weights are based on month-end market capitalization. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indices.

One of the primary factors that make IPOs look like an exciting and lucrative opportunity is the pop in share prices that often occurs on the initial day of trading. It is also a major contributor to the subsequent underperformance for individual investors. Institutions typically soak up the bulk of the allocation of newly issued shares, forcing individuals to purchase the shares in the open market once trading begins. By the time individuals are able to get access, it’s too late. The initial bounce has already occurred, and individuals effectively provide the exit for the institutions that received an initial allocation.

To illustrate this point, consider Airbnb’s IPO last Thursday. The company sold roughly 50 million shares at an initial-public-offering price of $68 a share. Despite the market opening at 8:30 AM CT, the first trade of Airbnb shares did not occur until 12:38 PM CT. During the first four hours of the trading session, the exchange aggregated orders to ensure the first trade(s) occurred at a fair price. The first trade consisted of a block of nearly seven million shares and executed at a price of $146, representing a roughly 114% gain. This means even if you were the very first in line to purchase shares of Airbnb, you missed the entire first-day gain.

Of course, there are times when individuals are able to participate in the initial share allocation, but there is an adverse selection problem here. The allocations that individuals can access are limited to ones the institutions don’t want, presumably because there is a high likelihood of poor performance.

Another factor that can lead to poor subsequent returns for IPOs relates to company insiders selling shares. As much as half of the shares held by insiders are subject to lock-up periods that may last 6-12 months. At the expiration of the lock-up period, selling by insiders can put downward pressure on share prices.

High market demand has allowed private companies to go public with very generous terms. This trend may continue to entice private companies to go public now, out of fear the market may soon turn less favorable. As investors see stories about large IPO gains, they would be well served to temper their expectations. Not all IPOs trade higher on the first day of trading, and the ones that do are generally not available for individual investors anyway. History has shown that investors are better off with a low-cost, diversified portfolio than they are trying to buy into IPOs. This is particularly true with valuations and sentiment as stretched as they are today.  

1. n DFA’s study, IPO stocks were represented by a hypothetical market cap-weighted portfolio consisting of IPOs issued over the preceding 12-month period, rebalanced monthly. By design, the hypothetical portfolio excluded the first day of trading for IPOs, as individual investors typically do not participate in the initial allocation.

WEEK IN REVIEW

  • The Federal Reserve begins the year’s last two-day meeting of the Federal Open Market Committee (FOMC) today. At the conclusion of the meeting tomorrow (1 PM CT), the committee will publish its official meeting statement and updated economic/rate projections. Shortly thereafter, Fed Chair Jerome Powell will hold his post-meeting press conference, which can typically be streamed on Yahoo Finance. Wall Street does not expect any changes to the level of its benchmark interest rate, but there are other items worth watching for. This includes guidance on the length of its bond-buying program, the maturity profile of the bonds it is purchasing, and updates to the Dot Plot.
  • While monetary policy has remained extremely loose, the market has been monitoring developments on the fiscal front. A narrow $750 billion stimulus package has been promoted by a bipartisan group of lawmakers that would extend unemployment insurance, provide relief for small businesses, and funding for vaccine distribution and schools.
  • There is a decent slate of economic data being published this week. Today we will get an update on industrial production, tomorrow we will get retail sales, service sector activity (PMIs), and the conclusion of the FOMC meeting, updated jobless claims data is scheduled for Thursday, and the Index of Leading Economic Indicators comes out on Friday.

HOT READS

Markets

  • America’s Small Stocks Are Leading the Market’s Charge (WSJ)
  • ‘It’s an Economic War’ – Warren Buffett Urges Congress to Extend Relief for Small Businesses (CNBC)
  • Ponzi Schemes, Other Investment Fraud on Rise During Pandemic, SEC Says (CNBC)

Investing

  • Could We See Record Stock Market Valuations This Cycle (Ben Carlson)
  • A Few Things I’m Pretty Sure About (Morgan Housel)
  • When the stock Market Is Too Much Fun (Jason Zweig)

Other

  • To Lose Weight With Exercise, Aim for 300 Minutes a Week (NYT)
  • Quantum Computing’s Growing Advantage (Axios)

MARKETS AT A GLANCE

Source: Morningstar Direct.

Source: Morningstar Direct.

Source: Treasury.gov

Source: Treasury.gov

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

Source: FRED Database & ICE Benchmark Administration Limited (IBA)

ECONOMIC CALENDAR

Source: MarketWatch

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ABOUT THE AUTHOR

402.763.2967

jjenkins@lutz.us

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JOSH JENKINS, CFA + CHIEF INVESTMENT OFFICER

Josh Jenkins is the Chief Investment Officer at Lutz Financial. With 10+ years of relevant experience, he specializes in assisting clients with portfolio construction, asset allocation, and investment risk management. In addition, he is responsible for portfolio trading, investment research and thought leadership for the division. He lives in Omaha, NE, with his wife Kirsten.

AREAS OF FOCUS
  • Asset Allocation
  • Portfolio Management
  • Research & Data Analytics
  • Trading System Operation & Execution
AFFILIATIONS AND CREDENTIALS
  • Chartered Financial Analyst®
  • Chartered Financial Analyst Institute, Member
  • Chartered Financial Analyst Society of Nebraska, Member
EDUCATIONAL BACKGROUND
  • BSBA, University of Nebraska, Lincoln, NE

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