Dec 10, 2020 Investment Question of the Month: IPO’s

INVESTMENT QUESTION OF THE MONTH: Should I invest in an Initial Public Offering (IPO)?

Through November 16th of this year, we saw 223 companies[1] make the transition from private to public through way of IPOs, the most since 2014. And we could potentially see over $100 billion raised in IPOs by the end of 2020. Momentum may continue in 2021 with potential IPOs for notable companies like Airbnb, DoorDash and Instacart.

Headlining the year so far is Snowflake, the largest IPO so far in 2020 and the largest ever for a U.S. software company. While there is much excitement that comes with the opportunity of early ownership and the allure of getting in on the initial action, investors should proceed with caution when considering investing in IPOs.

Accessing First Day Returns

While Warren Buffet’s Berkshire Hathaway may have been able to purchase $250 million in Snowflake stock prior to the IPO, most investors were not afforded this opportunity. IPOs are often associated with strong returns on the first day the shares become available, however, accessing these first-day returns requires an allocation from the underwriting banks. Researchers[2] have documented an adverse selection problem associated with IPO share allocations and find that allocations to IPOs having poor first-day returns have generally been easier to obtain, while allocations to IPOs with good first‑day returns have usually been reserved for certain clients of the underwriting banks.[3]

Snowflake’s recent IPO illustrates the difficulty for main street investors to capitalize on first-day returns. Snowflake sold 28 million shares at an offering price of $120 apiece. Shares opened to the public the following day at $245 and ended up closing at $254. For investors like Buffet who had the opportunity to get in at the offering price, they were able to make a pretty penny. However, the average investor did not enjoy nearly the same return.

IPO Restrictions

Generally, a large portion (typically 50% or more)[4] of the IPO shares are held by insiders and subject to lockup periods that prevent such insiders from selling on the open market for a specified time frame. Once the lockup restrictions expire, typically 180 days after the initial offering, these shares may be sold in the market. Studies show that lockup covenants not only limit the liquidity in the first few months after an IPO, but also contribute to downward pressure on the stock price after expiration, as many of the insiders flood the market creating a liquidation event. Dimensional Funds found that these restrictions contribute to underwhelming medium-term IPO performance, as most IPOs underperformed industry benchmarks in their first year.

IPO Performance

Looking out at longer term performance, Dimensional’s Research team conducted a study of 6,632 US IPOs that occurred from 1991 to 2018. The period is broken into two subperiods. The period from 1991 to 2000 is characterized by a relatively high IPO frequency rate of 420 per year. During the 2001-2018 period the IPO rate fell to 120 IPOs on average per year. Despite the average number of IPOs declining from the 1990’s, the average IPO offering size is almost three times larger over the most recent period, as compared to the initial 10 years in the sample.

Exhibit 1 compares the returns of the IPOs to the returns of the Russell 2000 (an index of small cap stocks) and Russell 3000 (an index of predominately large cap stocks) indices over the full sample period as well as two subperiods. The data shows that IPOs underperformed the Russell 3000 by more than 2% in the full sample period as well as in both subperiods. In comparison to the Russell 2000 Index, IPOs underperformed in the overall period and the sub-period from 2001-2018.

Exhibit 1: IPO Return Analysis, 1992-2018

 

 

IMPORTANT DISCLOSURES

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This newsletter is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual.  To determine which investments may be appropriate for you, consult your financial advisor prior to investing. All performance referenced herein is historical in nature and is not an indication of or a guarantee of future results. All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment.

Your experience may vary according to your individual circumstances and there can be no assurance that LRIA will be able to achieve similar results for all clients in comparable situations or that any strategy or investment will prove profitable.   As investment returns, inflation, taxes and other economic conditions vary, your actual results may vary significantly. The economic forecasts set forth in the presentation may not develop as predicted and there can be no guarantee that strategies promoted will be successful. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein, and take no responsibility, therefore.

Stock investing includes numerous specific risks including the fluctuations of dividend, loss of principal, and potential illiquidity of the investment in a falling market. International and emerging markets investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Initial Public offerings and private placements may be subject to higher degree of risk and may have lack of liquidity.  Small cap stocks may be subject to a higher degree of risk than more established companies’ securities. The illiquidity of the small cap market may adversely affect the value of these investments. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. This newsletter should not be regarded as a complete analysis of the subjects discussed. Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values and yields will decline as interest rates rise and bonds are subject to availability and change in price. The risks associated with investment-grade corporate bonds are considered significantly higher than those associated with first-class government bonds. The difference between rates for first-class government bonds and investment-grade bonds is called investment-grade spread. The range of this spread is an indicator of the market’s belief in the stability of the economy. The fast price swings in commodities and currencies can result in significant volatility in an investor’s holdings. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. The Value investments can perform differently from the market as a whole. They can remain undervalued by the market for long periods of time.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily consider the particular investment objectives, financial situations, or particular needs of all investors. For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.

Index Definitions

The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. The Russell 2000® Index is a subset of the Russell 3000® Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.

The Russell 3000® Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market.

[1] Renaissance Capital

[2] Ritter, Jay. 1987. “The Costs of Going Public.”

[3] Reuter, Jonathan. 2006. “Are IPO Allocations for Sale? Evidence from Mutual Funds.”; Jenkinson, Tim, Howard Jones, and Felix Suntheim. 2018. “Quid Pro Quo? What Factors Influence IPO Allocations to Investors?”

[4] Green, Kevin. Black, Stanley. 2019. “What to Know About an IPO.” Dimensional Fund Advisors

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Important Disclosures

Leonard Rickey Investment Advisors, PLLC (“LRIA”), is an SEC registered investment adviser located in the State of Washington. Registration does not imply a certain level of skill or training. For information pertaining to the registration status of LRIA, please contact LRIA or refer to the Investment Adviser Public Disclosure website (www.adviserinfo.sec.gov).

This is provided for general information only and contains information that is not suitable for everyone. As such, nothing herein should be construed as the provision of specific investment advice or recommendations for any individual. To determine which investments may be appropriate for you, consult your financial advisor prior to investing. There is no guarantee that the views and opinions expressed herein will come to pass. This newsletter contains information derived from third party sources. Although we believe these third-party sources to be reliable, we make no representations as to the accuracy or completeness of any information prepared by any unaffiliated third party incorporated herein and take no responsibility therefore.

Any projections, forecasts and estimates, including without limitation any statement using “expect” or “believe” or any variation of either term or a similar term, contained here are forward-looking statements and are based upon certain current assumptions, beliefs and expectations that LRIA considers reasonable or that the applicable third parties have identified as such. Forward-looking statements are necessarily speculative in nature, and it can be expected that some or all of the assumptions or beliefs underlying the forward-looking statements will not materialize or will vary significantly from actual results or outcomes. Some important factors that could cause actual results or outcomes to differ materially from those in any forward-looking statements include, among others, changes in interest rates and general economic conditions in the U.S. and globally, changes in the liquidity available in the market, change and volatility in the value of the U.S. dollar, market volatility and distressed credit markets, and other market, financial or legal uncertainties. Consequently, the inclusion of forward-looking statements herein should not be regarded as a representation by LRIA or any other person or entity of the outcomes or results that will be achieved by following any recommendations contained herein. While the forward-looking statements here reflect estimates, expectations and beliefs, they are not guarantees of future performance or outcomes. LRIA has no obligation to update or otherwise revise any forward-looking statements, including any revisions to reflect changes in economic conditions or other circumstances arising after the date hereof or to reflect the occurrence of events (whether anticipated or unanticipated), even if the underlying assumptions do not come to fruition. Opinions expressed herein are subject to change without notice and do not necessarily take into account the particular investment objectives, financial situations, or particular needs of all investors.

For additional information about LRIA, including fees and services, please contact us for our Form ADV disclosure brochure using our contact information herein. Please read the disclosure brochure carefully before you invest or send money.