Hot New Stock Offerings – Are They Worth It?

Mastercard is going public. You’ll finally be able to own shares in it. The question is, should you even want to?

Mastercard is just one of a pile of high-profile initial public offerings (IPOs) coming out in 2006. Other names include J. Crew, Morton’s Steakhouse, Tim Horton’s (mmm...) and various tech and energy names. With big-name IPOs coming out in 2006, should you get excited, and try to get in?

The last really high-profile new offering was Google in 2004. And it sure was a winner... Folks who bought it have already made several times their money.

But looking back over the last 35 years of IPO returns, it turns out Google is the exception to the rule. The truth is, you’re better off not chasing IPOs. Let’s take a look:

Jay Ritter, a professor at my alma mater (The University of Florida), studied the returns on IPOs from 1970 basically to the present. He found that IPOs actually underperform the overall stock market . They underperformed in the first year, the second year, and the third year after their introduction.

In fact, over the five-year period after their introduction, IPOs underperformed the stock market at an annualized rate of -4.1% per year . 

The underperformance was consistent across each decade, so it’s not a fluke. (One important point about Ritter’s numbers: they start at the end of the first day’s trading of the stock. Other studies by Ritter show that IPOs usually have a first day “pop” higher, above their initial offering price.)

So now we know that IPOs as a group underperform the overall market over the long run. Is there something profitable we can take from this?

I wondered...

I thought that if we knew which stock market sectors made up the largest portion of the IPOs in a year, then we’d know which sector was most loved by investors. Then we’d know which stock sectors are destined to underperform in the coming years.

I ran out of time for this article to run the numbers going way back. But the numbers I found at www.IPOhome.com support my idea...

In 1999 and 2000, tech stocks made up the lions share of IPOs, making up 66% of IPOs in 1999 and 47% of IPOs in 2000. Toward the end of this time, tech stocks (as measured by the Nasdaq) plunged over 80%, from a high of over 5,000 in March of 1999 to near 1,200 in late 2002.

New offerings in the health care/biotech area dominated the IPO market in 2001. They were THE hot thing. These stocks got crushed too... The Nasdaq Biotech Index (^NBI) peaked in mid-2001 at above 1,000, then crashed down to 400 in 2002.

Since then, the IPO market itself crashed. The number of deals shrank. The amount of money going into IPOs pretty much disappeared. New deals raised $97 billion in 2000. In 2003, the number was just $15 billion. With no wild speculation since 2001, I’m not sure the numbers since then tell us anything.

To sum up this article, don’t get too excited about IPOs. The press just needs something to talk about. The truth is, IPOs are nothing special... and the chances of finding another Google are just too slim. Outside of the first-day “pop,” chances are you’ll do worse than the overall market by buying IPOs, over both the short run and the long run.

You must especially avoid the “hot” IPO sector in the years after that sector is hot, like tech stocks in 1999, or biotechs in 2001. Currently, there is no hot IPO sector to steer clear from... although one thing is certain:

Every IPO in 2006 will be promoted as having Google-like potential, or we’ll at least be reminded of how well Google did. But the lesson of history is that this is simply hype. The truth is that there is no pot of gold in IPOs. So don’t buy into the hype.

Good investing,

Steve