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7 Reasons Why You Shouldn't Buy an IPO

Debbie Carlson

IPOs aren't always good investments.

Initial public offerings can gather a lot of buzz, but investors should think twice before blindly buying upcoming IPO stocks. While a few of these stocks rally in their debut -- such as SelectQuote (ticker: SLQT), which rose more than 30% in the first weeks after its late-May IPO -- most of them don't. In fact, some stocks flounder after their IPOs. Just look at Lyft (LYFT) and Uber (UBER), which are trading for less than their respective IPO prices a year later. Investors who are thinking about buying an IPO stock need to consider how it fits into their total asset allocation and risk profiles, says Connor Browne, portfolio manager for Thornburg Investment Management. "Stick to that, and try not to worry too much about the watercooler talk," Browne adds. Before you get swept up in 2020 IPO news, here are seven reasons not to buy an IPO.

Average investors can't buy at the initial price.

The "I" in IPO is a stock's initial offering price, but that price goes to investors who can get in on the deal early. Unless someone is a big client at a brokerage firm, average investors can't buy at the IPO price, says David Schneider, a certified financial planner at Schneider Wealth Strategies. "Allocations of hot IPOs are not in the cards for mere mortals," he says. Investors who are lucky enough to get a small IPO allocation won't receive enough shares for them make a significant financial impact. And even if someone can get a meaningful allocation to an IPO, that can be a red flag. "It means that the institutions passed on it," Schneider says.

IPOs may underperform benchmarks.

Schneider cites a recent research report from Dimensional Fund Advisors, which shows poor performance by IPOs. Dimensional studied the first-year performance of more than 6,000 U.S. IPOs from 1991 to 2018 and found that these stocks seemed to underperform industry benchmarks. "Generally speaking, it doesn't look like IPOs do particularly well relative to other stock market investments when you control for relevant risk factors," he says. Sometimes an investor has a connection to a company to buy shares at the IPO price for a hotly anticipated stock that is oversubscribed. But again, experts say retail investors don't get access to those shares.

Emotion can trump reasoning.

IPO buyers can easily be swept up in popular consumer trends. Retail investors can get lost in the zeitgeist of a hot IPO -- especially when it comes to tech names -- and let the fear of missing out, or FOMO, override logic on a popular investment. One of 2020's highly anticipated upcoming IPOs is food delivery company DoorDash, which has benefited from increased demand during the pandemic. But people need to decide if a trend is a fad or something sustainable, says Jerry Raio, managing director and head of capital markets at ClickIPO Holdings. "Will that trend continue to be as popular six months from now? That is something that people need to think about if they are going to invest in IPO," he says.

Valuations still matter.

Hot IPOs can see their share prices rise sharply in the first few days and weeks of trading, sending valuations to outsize levels, with high price-earnings ratios. Shares of cloud software company ZoomInfo Technologies (ZI), for example, jumped nearly 100% when the company debuted this month -- pushing the company's market cap to $15 billion. That can limit future growth because so many expectations are already priced in. When it comes to popular trends and fads, people need to consider if all the benefits a company delivers are represented in a stock's price, Raio says. "What does the competitive landscape look like? You have to look at the competitive advantage or unique technology that gives them a sustainable competitive advantage," he says.

IPOs have little real-world valuations.

A company uses underwriters to help set a valuation and establish an IPO price. The IPO price is based on the due diligence underwriters perform at the time, and the price is typically at a discount to the publicly traded peer group, Raio says. When an IPO hits the stock market, it's part of the secondary market, where most equities are traded. "Once it's trading in the secondary market, you're flying blind as to what the valuation of it is," he says. It isn't until after the stock starts trading that outside analysts get a chance to review the company.

Research is important.

Investors shouldn't look at IPOs any differently than they would look at any other stock publicly available to buy, Raio says. Investors still need to do their analyses to understand the company, the industry in which the company competes and the company's valuation. That means following established valuation metrics, which entails looking at P/E and price-to-book ratios, debt levels, and other competitive risks, along with reading up on the management team and how it runs the company. "People need to realize it's like buying any other equity security," Raio says.

Prices may tumble after the lock-up period.

Private shareholders and other insiders who were able to get in on the actual IPO price have their shares locked up before they can sell, usually for 180 days. After that lock-up period, they can sell their shares. For stocks that have experienced sharp price rallies, the end of the lock-up period can be an insider's chance to cash out and take the profits, which will push down prices. Schneider says investors who have done their homework in the intervening six months and still like the company's valuations may be able to buy the stock at a better price. "You can make a sober decision as to whether or not this is something you really want to invest in rather than doing it in the sort of frenzy and volatile trading after it initially comes public," he says.

Seven reasons to reconsider buying an upcoming IPO:

-- Average investors can't buy at the initial price.

-- IPOs may underperform benchmarks.

-- Emotion can trump reasoning.

-- Valuations still matter.

-- IPOs have little real-world valuations.

-- Research is important.

-- Prices may tumble after the lock-up period.

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