Swedroe: IPO Prices Boosted By Hype

Initial public offerings (IPOs) involve a great deal of uncertainty, which makes them a relatively risky investment. Thus, investors should receive higher expected returns as compensation for the greater amount of risk that’s associated with them. However, the evidence shows that unless you are well-connected enough to receive an allocation at the IPO price (and then get out quickly), IPOs make poor investments.

Professor Jay Ritter of the University of Florida has done a series of studies on IPO performance, which you can find on his website. His most recent study, updated in April 2015, covered the period beginning in 1980 and includes returns data through 2014.

Comparing IPO returns after the first day’s trading to similar listed stocks, Ritter found that, on an equal-weighted basis, they underperformed other firms of the same size (market cap) by an average of 3.1 percentage points per year during the five years after issuing (not including the first-day return).

The underperformance relative to other firms of the same size and book-to-market ratio averaged 2.0 percentage points per year. Clearly, investors were not rewarded for taking on the incremental and idiosyncratic risk of IPOs. So what’s going on? There are two explanations in the literature: the lottery effect and the winner’s curse.

The Lottery Effect And The Winner’s Curse

Investors display a preference for “skewness” in returns, meaning they’re willing to accept the high probability of a below-average return in exchange for the small chance of earning an outsized return should they find the next Google.

This is what’s frequently referred to as the “lottery effect.” Investors tend to place high subjective valuations on large but low-probability gains. The lottery effect phenomenon becomes especially pronounced in times of high investor sentiment. Due to a positive skewness of returns and high valuations at the beginning, these IPOs tend to underperform in the long run.

Eric Falkenstein explains the winner’s curse in his book, “The Missing Risk Premium.” Let’s say you have to guess the number of jellybeans in a jar. If you average together the guesses of a large crowd, it usually ends up being very close to the actual number. While some individual guesses can be off by a wide margin, the really low guesses offset the really high guesses.

Now imagine this group in the context of an auction. Averaging together the maximum price that each individual would pay for an item would give you a very close approximation of its true value.

But that’s not the way an auction works. The person who wins the auction is the one willing to bid the highest. That’s obviously higher than the average price (or approximate value) of the item, meaning the person will almost certainly overpay for it.

With a stock, some investors will value it higher than the market average, and others will value it lower. That balance is what gives stocks their price. However, IPO stocks may not have that same dynamic for a few reasons:

• There may not be enough stock available for pessimistic investors to short (and drive its price down), and a limited supply of lendable stock can create high borrowing costs.
• Institutional investors may have charters preventing them from shorting stocks.
• Individual investors may be too fearful of the unlimited loss potential associated with shorting.

The end result is that it’s the optimistic investors who are driving prices, causing the initial jumps associated with many IPOs.

IPOs With Negative Earnings

Severin Zorgiebel contributes to the literature on the performance of IPOs with his February 2016 study, “Valuation of IPOs with Negative Earnings.”

He noted: “About half of all initial public offerings (IPOs) in the U.S. between 1994 and 2013 were initiated by companies with negative earnings. Especially during the dot-com phase, young high-tech companies initiated IPOs even when there was no product developed, no profits earned, and oftentimes not even any sales. Interestingly, these firms found investors who were willing to invest in order to receive a portion of a promising idea that might turn into a multibillion dollar business.”

In other words, they were buying lottery tickets. But this isn’t just a dot-com craze. Very prominent IPOs like Groupon, Twitter or Tesla are recent examples of IPO companies with negative earnings and very high valuations well after their dot-com phase ended.

Zorgiebel sought to answer the question: Are IPO companies with negative earnings valued higher compared with other IPOs? And if they are, what are the drivers behind these potentially high valuation levels? Finally, he sought to test how these IPOs perform in the long term.

He used a variety of valuation models provided in previous studies, and implemented one from the field of M&A (used to evaluate how far the valuation of a target deviates from a “fair” value based on comparable companies in the market). Zorgiebel adjusted the models based on the previous findings in the literature (especially regarding growth).

The models look at such accounting metrics as book value, net income, leverage and growth expectations. Firm size is also accounted for. Zorgiebel then created matching peer groups of companies.

Zorgiebel’s data set included U.S.-based IPOs between 1994 and 2013. Penny stocks with offering prices below $5 as well as IPOs from the financial sector were excluded. Forecasts and growth expectations were based on IBES data. Press coverage was measured in terms of number of articles in the entire LexisNexis universe (with the IPO company mentioned in the article or headline beginning six months prior to its issue date). The final sample consisted of 2,655 IPOs with total proceeds of about $335 billion.

Findings On Negative Earnings IPOs

Following is a summary of Zorgiebel’s findings:

• IPO companies with negative earnings are more likely to have venture capital (VC) backing, are younger, are more likely to be high-tech companies and are smaller in terms of sales.
• IPO companies are valued higher compared with listed peer companies. The results hold for the periods before and after the dot-com phase, and are not only driven by high-tech companies but are spread across a variety of industries.
• In general, there is a 38% valuation premium for IPOs compared with listed companies in the sample.
• High valuation levels are influenced by marketing campaigns undertaken by VCs and underwriters, and do not seem to be based on financial fundamentals.
• IPOs with negative earnings tend to be valued much higher compared with IPOs with positive earnings (66% versus 19% median valuation premiums) and they have greater levels of press coverage.
• IPOs with VC backing, a high underwriter ranking, that are small in size and have low leverage, high R&D expenses and high EPS growth rates offer higher valuation premiums. VC backing, underwriter ranking and EPS growth play an especially important role. Firms with VC backing and high-quality underwriters offer lower margins and greater levels of press coverage.
• Market participants adjust market prices over time after the IPO. As many of the loss-making IPO companies fail to monetize their high growth expectations over the long term, valuation premiums trend downward to the valuation levels of other IPO companies. As a result, IPO companies with negative earnings underperform the market and other IPO companies.
• In general, IPOs with negative earnings underperform in terms of share price performance after a period of 12, 24 and 36 months following the IPO. In the medium term of six months, no significant effect can be found (note the lockup period typically ends after six months). The underperformance of IPOs with negative earnings is even stronger compared with IPOs with positive earnings after 12, 24 and 36 months.

Interestingly, Zorgiebel found that IPOs with positive earnings are slightly undervalued compared with listed companies (-3%). This, along with his other findings, is consistent with those from prior research.

Another interesting finding was that the percentage of floated shares (out of the total number of shares outstanding) is highly negatively correlated with valuation premiums.

This is logical because the smaller supply may act as a signaling device that previous shareholders have confidence in the future. It also reduces agency risks. And the smaller supply itself is a positive. Observe that a small float also increases the difficulty and cost of obtaining shares to short. Limits to arbitrage allow overpricing to persist.

Hype Helps Drive IPO Prices
Zorgiebel reached the following conclusion: “In a market environment of high uncertainty, heterogeneous beliefs, misperception of risk and return, and overconfidence, IPOs with negative returns might be different and more exposed to marketing hype than other IPOs. This effect is fueled by the influence of VCs and underwriters.”

He added: “Investors ‘learn’ over time and reflect reporting changes in the firm valuation. When initial IPO valuation is driven more by overconfidence than on market fundamentals, new information causes firm valuation to become closer to its intrinsic value due to lower information asymmetries. Investor overconfidence seems to play an integral role when IPO firms have negative earnings, which makes a fundamental valuation difficult to perform.”

The literature supports his view on the influence of investment banks and VCs, as it shows that there is a close relationship between the involvement of investment banks, marketing of IPOs and valuation. Investment banks have an incentive, due to their fee structure, to promote IPOs, induce sentiment investors and, consequently, to increase the valuation.

Similarly, VCs, especially highly reputable VCs, have not only a certification role, but also market power. However, these valuation levels are not sustainable, and decrease over time.

The bottom line is that there is a large body of evidence on the relatively poor performance of IPOs. Zorgiebel contributes to the literature by showing the importance that IPOs with negative earnings have in the overall poor performance of IPOs.

If you’re considering investing in IPOs and accepting their idiosyncratic risks, the evidence presented should serve as a strong warning that your investment may well be driven by overconfidence.

The fact that IPOs have performed poorly has been long known in the literature. It’s why fund families such as Dimensional Fund Advisors avoid their purchase. (Full disclosure: My firm, Buckingham, recommends Dimensional funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.