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IPOs are hot. Don’t get burned

Lyft logo.
Lyft logo.Patrick T. Fallon/Bloomberg

Who doesn’t love to dream about hitting the jackpot? The excitement around Wednesday night's Powerball drawing (estimated payout: $750 million) was palpable. A similar exhilaration is building on Wall Street with a series of blockbuster initial public offerings, the investment banker’s version of the lottery.

The action begins Thursday evening, when Lyft is poised to price its shares at a level that will raise $2.2 billion and value the ride-hailing company at nearly $24 billion. Rival Uber isn't far behind in the IPO queue with a deal expected in April or May that could give it a market capitalization of $120 billion.

And the San Francisco-based taxi killers aren't the only big companies preparing to hit the street this year. IPOs are also likely from Pinterest (image search), WeWork (co-working offices), Palantir (big data). They are standouts in the startup cohort that grew into “decacorns” (those with a private market value of more than $10 billion) and they follow a previous generation of IPO stars led by Google, Facebook, Twitter, Snap.

IPOs come in waves when the market is strong, with entrepreneurs and their venture capital backers rushing in before the window of opportunity closes. If they are selling, should we be buying?


For most of us, the answer is no.

And that’s not just me. There’s good research challenging the wisdom of ordinary investors betting on new stocks.

First, however, the exception.

Getting in on the ground floor of an IPO — buying at the offer price set by the company — is usually a good deal. The average first-day return on IPOs was nearly 16 percent last year, according to Renaissance Capital.

That happens because the investment bankers who manage IPOs want to make sure that there is a first-day “pop” when the stock starts trading. They do this by pricing the shares below fair market value. The pop creates positive buzz and spurs interest in their other deals.


But it's hard to get in on the ground floor because brokers hand out IPO shares to favored customers like they were Christmas gifts. If you have the juice to get the shares, then buy ’em and flip away, but keep in mind that the 16 percent pop is an average. About a quarter of all deals end the first day in the red, Renaissance Capital data show.

How shares get dished out to unsophisticated investors is a real problem, said Chester Spatt, professor of finance at Carnegie Mellon’s Tepper School of Business and a visiting professor at the Sloan School at MIT.

“You may get very few shares if it’s a good IPO, and get all you want if it’s a bad one,” he said.

Sure, you can buy the stock in the open market once it starts trading, as most investors do, and still make money. But it gets harder.

Research by Jay Ritter, a finance professor at the University of Florida who studies IPOs, shows that if you buy at the closing price on the first day and hold for three years, returns lag behind the market by about 18 percent.

Why is that?

Sometimes, the first-day gains bring the shares up to, or beyond, fair value. That was the case with Snap, maker of Snapchat, the popular messaging service. Its shares soared 44 percent on their first day. A year later, they were up just 1.2 percent while the Standard & Poor’s 500 index had added 25 percent. Too much pop is actually not a good thing.


Moreover, companies time their IPOs to hit the market when investors are bullish. This helps them get a high price even with the discount built in by their bankers.

And despite a few bumps, this year has been an exceptionally good one for stocks. The S&P 500 is up nearly 12 percent, on track for the best quarter since the first three months of 2012.

It makes sense that the Lyfts and WeWorks of the world, which have remained in private hands much longer than many startups, are eager to launch IPOs before the decade-old bull market runs out of steam.

“IPOs occur in cycles,” said Nikunj Kapadia, professor of finance at UMass Amherst’s Isenberg School of Management. “When the share of equity issued is very high relative to new debt, subsequent one-year market returns tend to be negative. . . . Companies time the market when they think there is a top.”

One final point about this year’s crop of prospective market rookies. They are big, growing fast — and losing a ton of money. Lyft’s revenue doubled last year to $2.16 billion. But its net loss widened 32 percent to $911 million.

“Investors should be doubly cautious when excessive valuations are paired with excessive losses,” said Matthew Kennedy, senior IPO market strategist at Renaissance Capital. “The IPO market is not for the faint of heart.”


This is all a long way of explaining why betting on IPOs isn’t a good idea for most average investors. If you must, stick with established, profitable companies that decide to go public. Jeans maker Levi Strauss is up 31 percent since it went public on March 20.

Or wait for the dust to settle on a hot startup IPO. Facebook, for example, went public at $38 a share in May 2012 amid a torrent of hype. After one year, you could buy it for almost a third less. If you had bought 100 shares of Facebook then, you’d be sitting on a profit of nearly $14,000.

Like most things in life, timing is everything. And patience is a virtue.

You can reach me at larry.edelman@globe.com and follow me on Twitter @GlobeNewsEd. Sign up for my Talking Points AM newsletter here.