Should You Invest In IPOs? It's Still A Risky Prospect

IPO written on wooden blocks with jar of money behind the blocks

(Image credit: Getty Images)

published 23 November 2023

Do you let hope triumph over experience in your love life? Go for it. But in your investment portfolio? That's where you need to harden your heart. Nowhere is the conflict between hope and experience starker than the market for initial public offerings, or IPOs.

The possibility of getting in on the ground floor of a young company is enticing. And for some of the lucky few who are given allotments of shares at the official starting price, a first-day IPO "pop" in share prices can create instant profits.

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The rout in tech stocks suppressed IPO activity in 2022, when just 65 deals raised less than $10 billion overall, says Josef Schuster, founder of IPOX Schuster, a financial services firm specializing in IPOs. That was down from 365 deals in 2021 that collected $134 billion from investors. Through the first nine months of 2023, a total of 76 IPOs have already gathered almost $15 billion from investors. And Schuster expects the rebound to continue through 2024. Among the firms that have hinted at upcoming IPOs: artificial intelligence company Databricks, veggie burger maker Impossible Foods and financial technology company Stripe.

IPOs continue to generate buzz despite their poor long-term track record for investors, making it important for new investors to understand what an IPO is. Between the start of 1980 and year-end 2022, the majority of IPOs lost money over the three- and five-year periods following their debut – even for investors lucky enough to buy at the official offering price, according to an analysis by University of Florida finance professor Jay Ritter. Regular investors did worse.

For investors who can tolerate the risk, it's okay to add a smidgen – though only a smidgen – of IPOs to your portfolio now, says Brian Duncanson, a fee-only financial adviser in Vero Beach, Florida. Bear in mind that for every Tesla, there is at least one WeWork (WEWKQ), which is down 99% since its 2021 debut and recently filed for Chapter 11 bankruptcy protection. "If an IPO is going to be a loser, you only want to lose a little. If it is going to be a winner, you only need a little," says Duncanson.

IPOs can provide some diversification from the mega-size companies dominating the S&P 500, says IPOX's Schuster. And as the IPO market recovers from the 2022 plunge, the stocks launching now are more likely to be "high quality and well vetted," he adds. An example, he says, is 249-year-old footwear maker Birkenstock (BIRK), which went public this fall, with more than $200 million in profits on $1.3 billion in sales in 2022.

First, pay attention to the way a firm goes public. In a traditional IPO, a company hires a Wall Street brokerage to help it complete paperwork, choose a starting price and drum up support among investors. Another common method of going public has been worse for investors: Hundreds of companies have merged with "special purpose acquisition companies" (SPACs), which are shell companies that have already sold shares to the public. But according to Ritter, from the start of 2012 through year-end 2022, the average SPAC has traded for less than half its first-day closing price as a newly merged company at the following one-year and three-year marks.

It's safer to focus on bigger deals and larger companies, says Ritter. Very small IPOs – which he defines as those that raise less than $30 million – tend to "shoot up the first day, then almost immediately collapse," he says. And look for significant revenues. Going back as far as the start of 1980 through 2022, IPOs of companies with more than $100 million in annual sales had a cumulative three-year return of more than 36%, Ritter found, while companies with revenues below that cutoff returned less than 8%.

Duncanson suggests making a list of IPOs you're interested in and waiting at least six months to see how the stock and the business perform. Then, if you're still interested, set a reasonable price target. IPOs are "the cutting edge of business. But the failure percentage is so high. Wait out at least two quarterly reporting cycles to see if they have overhyped and underdelivered," he says, adding that tech-sector IPOs, in particular, have been plagued by "irrational pricing."

Sara Russo, a technology industry analyst for investment firm Bernstein, notes that ARM is large and profitable. It's on pace to rack up about $2.7 billion in sales and more than 50 cents a share in profits in 2023, according to company estimates, says Russo. ARM stock opened at $51 a share, jumped to more than $63 within minutes and over the next two weeks dropped back to the low $50s. That's still too expensive and risky, in Russo's view. She'll consider the shares a better deal if by April ARM delivers on promises to make more inroads into the booming artificial intelligence market and if the stock drops to about $46 a share.

The company, on track to report more than $700 million in sales in 2023, is opening an average of about one new restaurant each week. Six of the nine analysts following the stock are currently bullish. Morgan Stanley restaurant analyst Brian Harbour is more in the neutral camp with an Equal Weight (Hold) rating. He has set a 12-month price target for the stock of $45 a share, implying a 45% gain from recent levels, but suggests that investors watch closely to see how the firm handles its rapid growth over the next year. "With experience, it's hard to have a Panglossian view of any restaurant IPO early on," he warns.

More than 40% of the portfolio of the aforementioned Federated Hermes Kaufmann Small Cap Fund (FKASX, expense ratio 1.36%) consists of stocks bought at their IPO. Despite getting the low initial offering prices, the actively managed fund, with $4 billion in assets, ranks in the bottom 60% of small-company growth funds so far this year, as well as in 2021 and 2022, according to fund tracker Morningstar. Strong gains from 2015 through 2020 give it a category-beating annualized 10-year return of 10.3%, however.

Neither of the two largest IPO index ETFs gets access to low initial offering prices. The largest IPO fund, with more than $700 million in assets, is the First Trust US Equity Opportunities ETF (FPX, 0.61%). The fund follows an index of 100 of the largest and most liquid IPOs, spinoffs and SPACs launched over the past four years. Losses in some of its largest holdings – including Airbnb (ABNB), down about 5% from its first-day close in December 2020 – have weighed on recent returns. The fund notched a 7.1% gain so far this year but lost an annualized 4.1% over the past three years.

The Renaissance IPO ETF (IPO, 0.60%), with $188 million in assets, is more concentrated, with only about 70 stocks. It has been volatile; before this year's strong gains it plunged 57% in 2022, when the S&P 500 index lost only 18%. The fund has ranked in the top half of mid-cap growth funds in three of nine calendar years, as well as so far this year; it ranked in the bottom half in six of nine years.

Kim Clark is a veteran financial journalist who has worked at Fortune, U.S News & World Report and Money magazines. She was part of a team that won a Gerald Loeb award for coverage of elder finances, and she won the Education Writers Association's top magazine investigative prize for exposing insurance agents who used false claims about college financial aid to sell policies. As a Kiplinger Fellow at Ohio State University, she studied delivery of digital news and information. Most recently, she worked as a deputy director of the Education Writers Association, leading the training of higher education journalists around the country. She is also a prize-winning gardener, and in her spare time, picks up litter.