The Bad News About IPOs

Value Added

The Bad News About IPOs

Investing in initial public offerings is a loser’s game. And the new JOBS law makes them even worse.

Hot IPOs can get pulses racing -- even those of people who normally don’t give a fig about stocks. The initial public offerings of Carbonite (symbol CARB), Groupon (GRPN), LinkedIn (LNKD) and Pandora Media (P), all of which debuted in the past 12 months, caused quite a stir. Just one thing: All except LinkedIn are now trading below their IPO prices.

SEE ALSO: Our Special Report on How to Be a Better Investor

These four IPOs are minnows compared with Facebook’s whale of an IPO, set for May. But before you decide to join in the Facebook excitement, remember: IPOs are usually bad investments.

Jay Ritter, a finance professor at the University of Florida in Gainesville, examined all IPOs from 1970 through 1993. In the first five years after they went public, IPOs returned, on average, 5.6 percentage points per year less than stocks of established companies with similar market values (share price times number of shares outstanding).


Another study, by CommScan LLC, an investment-banking research firm, found that the average IPO issued from 1990 to 1998 lagged Standard & Poor’s 500-stock index by 7.9 percentage points in its first year of trading.

That IPOs tend to go sour shouldn’t be a surprise. The owners of a company going public seek to sell at the highest price possible. So they try to put the brightest possible sheen on a company just as they sell shares. Plus, less information is available about companies going public than about established companies. And unseasoned companies make up most IPOs.

The Misnamed JOBS Act

Given these facts, investors ought to worry about the Jumpstart Our Business Startups (JOBS) Act, which President Obama signed into law on April 5. The new law has numerous provisions -- but all are designed to allow companies to sell stock to the public with less regulatory oversight.

How this law gained bipartisan support just four years after inadequate regulatory oversight helped trigger the worst financial crisis since the Great Depression is beyond me. It seems the only thing worse than partisan gridlock is bipartisanship.


One provision of the misnamed JOBS Act raises from 500 to 2,000 the number of shareholders a company may have before it has to start reporting financial statements to the public. Excluded even from the 2,000 limit are any shareholders who climb aboard thanks to a new phenomenon called crowd funding.

Crowd funding allows start-up companies to raise up to $1 million over the Internet from the general public outside normal regulatory channels that apply to other publicly traded companies.

“You take tiny stocks, and you use the Internet to hype them. What could possibly go wrong?” Barbara Roper, director of investor protection for the Consumer Federation of America, asks sarcastically. Many consumer and investor advocacy groups, as well as Mary Schapiro, chairman of the Securities & Exchange Commission, opposed the legislation. (See also: Does the SEC Have Your Back?)

History is filled with stories of scam artists bilking small investors by promoting stocks of tiny companies. The advent of the Internet has made it easier for con men to cheat unsuspecting investors. Typically, unscrupulous people hype a thinly traded stock on the Web, lure the unwary into buying, and then dump their shares at a profit. The new law will make it much easier to issue these tiny stocks. Columnist Chuck Jaffe, who panned the legislation on, wrote, “The most promising startup in this new environment might be a boiler-room pump-and-dump operation.”


Another provision in the new law allows many companies to escape some of the Sarbanes-Oxley regulation enacted after the accounting scandals of the early 2000s. Remember Enron, WorldCom and Tyco International? I’d prefer never to see another corporate blow-up like those.

Even under the old regime, small investors often got screwed. Groupon went public last November 4 at $20 a share and rose to $31 on its first day of trading. The stock closed on April 5 at $14.18, with a chunk of the slide occurring after questions were raised about Groupon’s accounting practices. (Kiplinger recommended the sale of Groupon's stock in a story posted on its Web site on March 6.)

What’s an investor to do? The answer is to be more careful than ever, particularly when putting money into IPOs and tiny companies. Caveat emptor.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

ORDER NOW: Buy Kiplinger’s Mutual Funds 2012 special issue for in-depth guidance on the only investments you need.