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7 Reasons Why You Shouldn't Buy an IPO

Debbie Carlson

IPOs can be a bad investment.

This has been a big year for initial public offerings, but investors should think twice before buying a new IPO stock blindly. For every IPO that sizzled, like Beyond Meat (ticker: BYND) which debuted in May around $45 and soared higher than $225, there are those that fizzle. Two recent IPO stocks, Lyft (LYFT) and Uber (UBER), are trading at less than their respective IPO prices. Connor Browne, portfolio manager for Thornburg Investment Management, says investors who are thinking about buying a new IPO stock need to consider how it fits into their total asset allocation and their risk profiles. "Stick to that and try not to worry too much about the watercooler talk," Browne says. Here are seven reasons not to buy an IPO.

Average investors can't buy at the initial price.

The "I" in IPO is the stock's initial offering price, but that price goes to investors who were able to get in on the deal ahead of time. 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 to have it make a significant financial impact for them. If an individual can get a meaningful allocation to an IPO, that can be a red flag. "It means that the institutions passed on it," he says.

IPOs may underperform benchmarks.

Schneider cites an August research report from Dimensional 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 these stocks generally underperformed 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. There are individual cases, in which an investor has some sort of connection to a company to buy shares at the IPO price of a hotly anticipated stock that is oversubscribed, but again, retail investors don't get access to those shares, experts say.

Valuations still matter.

Hot IPOs can see their share prices rise sharply in the first few days and weeks of trading, sending the valuations to outsized levels, with price-earnings ratios high. Browne says that puts pressure on the company to "do incredible things" to make the stock meet the expectations that those high share prices suggest. Many of the IPOs that came on to market this year reported negative earnings before their IPOs, he says. "Investors need to think for a moment about what sort of expectations are embedded within the valuations of some IPOs we've seen recently," he says.

IPOs have little real-world valuations.

To establish an IPO price, a company uses underwriters to help set a valuation. 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, says Jerry Raio, managing director and head of capital markets at Click IPO Holdings. Once an IPO hits the stock market, even on the first day of trading, it's part of the secondary market, which is where the vast majority of 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 analysis to understand the company, the industry the company competes in and the company's valuation. That means following established valuation metrics such as looking at price-earnings ratio, price-book, debt levels and other competitive risks, plus reading up on the management team and how they run the company. "People need to realize it's like buying any other equity security," Raio says.

Emotion can trump reasoning.

Retail investors can get caught up in the zeitgeist of a hot IPO and let the fear of missing out on a popular investment override any logic. Other people buy into the hype because they believe someone else is going to pay a higher price. "Buy it because you believe in the fundamentals of the company and you think the valuation is warranted," Raio says. Other average investors may want to buy an IPO because they like the company's product and think back to the investing edict of "buy what you know." But Raio says that's poor thinking. Knowing and liking the product "just tells you about a company's revenue," he says.

Prices may tumble after the lockup 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 180 days. But after that lockup time, they can sell their shares. For stocks that have experienced sharp price rallies, the end of the lockup time can be insiders' chance to cash out and take their 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 it cheaper. "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 initially comes public," he says.

Seven reasons to reconsider buying an IPO:

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

-- IPOs may underperform benchmarks.

-- Valuations still matter.

-- IPOs have little real-world valuations.

-- Research is important.

-- Emotion can trump reasoning.

-- Prices may tumble after the lockup period.

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