IPOs: Buy Value, Not Stories

October 30, 2015

This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Rusty Vanneman, chief investment officer of Omaha, Nebraska-based CLS Investments.

Everybody loves a good story. Stories entertain, inform and educate. They can also spur action, including among investors.

However, the problem is that stories often disrupt proper investing behavior, whether it’s building appropriate portfolios based on investment objectives or selecting individual securities to populate a portfolio. On the latter, security selection should primarily be about assessing an investment’s yield, the potential sustainable future growth in that yield, and its valuation. An expected return is derived from these building blocks, not the stories that surround them.

The IPO Story

Compelling stories attract investors to one area of the market in particular, “initial public offerings,” securities that represent the first sale of equity by a company to the public. These companies usually have a hot growth story to tell—and an expensive price tag to go with it.

Regretfully, because the story is so compelling, investors will often pay too much for an IPO. Various studies have shown, despite some sensational stories to the contrary, that IPO investing is typically a net loser for many individual investors.

There are valid arguments to own IPOs, including the benefit of having exposure to companies before they hit the major indexes. The exposure is truly unique for at least a short while (certain names don't ever hit the indexes). IPOs can also be viewed as an innovation play and provide indirect exposure to private equity.

2 Good Options For IPO Investors

Nonetheless, if one is going to invest in IPOs, a solid recommendation is to use an exchange-traded fund. ETFs are diversified and liquid—two attributes that many IPO investors do not get when they invest in individual securities. There are two strong ETF providers that currently offer domestic as well as international ETFs: First Trust and Renaissance.

First Trust had the first IPO ETF: the First Trust US IPO (FPX | A-74), which launched in 2006. This ETF has some rules that help limit some of the damage done to many individual investors. First Trust also has an international version, the First Trust International IPO (FPXI | F-44).

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