One of the top buzzwords in capital markets is “IPO”, or Initial Public Offering. With many young companies going public faster than ever, investors have become more and more interested in buying during an IPO. There are only a handful of stocks that receive more hype than IPOs, but there are also only a handful of stocks that are more risky than IPOs, and here’s why.

 

Lack of Data

Most fundamental equity research requires a look at historical financials to determine the company’s outlook. While this is hard enough to do with established companies, an IPO company is even more difficult to analyze because of the lack of historical information. Often the most useful information for IPO companies comes from the investment banks that are underwriting the IPO themselves, leading any rational investor to recognize the conflict of interest and avoid the noise.

 

The Lock-Up Period

When a company files for an IPO, the underwriters require all company management and stock-granted employees to sign a lock-up agreement. This agreement essentially prohibits the company insiders from selling any shares of the stock for a set period of time, usually 3 to 24 months, with a minimum of 90 days. This is important for investors because when the lock-up period expires, there is typically a rush of company insiders looking to sell their stock, which causes the stock price to drop as the supply of available shares increases.

 

The Premium Valuations

While it would be ideal if all stocks trades based on their intrinsic value, this is not the case. Many companies are valued for their potential relative to competitors, as well as valuations based purely on market hype. In an IPO, since the company is getting more attention than most other companies, it’s valuation is often is often over-hyped. For example, Etsy.com, an e-commerce website focused on handmade or vintage items, went public in April. Because of the massive hype surrounding their IPO since they were a private company, ETSY soared to almost $36 in their IPO. However, as the chart shows, the stock currently trades under $10, a 68% decline.

 

ETSY_chart_peloton_wealth

All things considered, IPOs are generally unattractive investment options for fundamental investors with long-term horizons. If you can master market timing, as well as completely understand market sentiment, IPOs may provide a way to gain quick returns. However, this borders on pure speculation, which is the enemy of any rational investor. If a company is of particular interest for reasons beyond the IPO hype, such as strong competitive advantage, superior management, or industry-changing research, an investor might look to buy the stock months after the IPO, when the price reaches a more reasonable level.

 

***

Peloton Wealth Strategists does not own the common stock of Etsy.  The opinions expressed above should be construed as neither investment advice nor a solicitation to buy or sell securities.  Peloton Wealth Strategists assumes no liability for losses pursuant to investment actions entered into as a result of opinions expressed herein.  Changes in economic and capital market conditions and the unique objectives of each investor should be considered before investing in securities.