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Warren Buffett: Why IPOs Can Be Painful for Investors

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- By Rupert Hargreaves

This year there have been over $100 billion worth of IPOs in the U.S. Companies have rushed to take advantage of investors' high demand, especially for technology businesses and SPACs. In the first week of December alone, the market saw eight IPOs and ten SPACs raise $3.9 billion.

Investor demand has been so high that some IPOs have doubled on their first trading day. DoorDash (NYSE:DASH) soared 86% in its trading debut, and Airbnb's (NASDAQ:ABNB) shares closed their first day up 113%, including so-called greenshoe shares.


Only time will tell whether or not investors achieved a good deal buying these stocks on their first day of trading. However, more often than not, buying equities at their IPO is not the best course of action for long-term investors.

IPO prices

Research conducted by Dimensional Fund Advisors found that across 6,000 IPOs from 1991 to 2018, the average one-year return was less than 4%, underperforming the Russell 2000 by 2% on average.

The problem with IPOs is that they are orchestrated to achieve the best result for selling investors. Warren Buffett (Trades, Portfolio) once noted that these deals, which are effectively negotiated to achieve the best price for the sellers, put buyers at a disadvantage.

The Oracle of Omaha explained this concept at the 2004 annual meeting of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) shareholders:


"An IPO situation more closely approximates a negotiated deal. I mean, the seller decides when to come to market in most cases. And they don't pick a time necessarily that's good for you.

... It is more of a negotiated sale. And negotiated transactions are very hard to get bargains. If you take the houses in Omaha, you know, somebody that lives next door to somebody who sold their house for $80,000...and their house is more or less comparable, they're not going to sell it for $50,000. It just doesn't happen... That's what happens in negotiated sales."



The CEO of Berkshire Hathaway went on to explain the same does not happen in an auction market. If you have a whole bunch of different owners of one house in Omaha, and they all own a small percentage, "they might sell at damn near anything."

This is where the opportunity would lie for the patient, long-term investor. Occasionally, Buffett noted, the small pieces of the house would "sell at crazy prices." He went on to say:


"In my view, you're way more likely to get incredible bargains in the in an auction market. It's just the nature of things...Sometimes there will be IPOs in terrible markets, and they may come very cheap. But by and large, that is not when IPOs come. They come when the seller thinks that the market is ready for them. And they come with an informed seller thinking it's a pretty good time to go public. And, you know, you'll make better buys, in my view, in an auction market."



This advice is as important to remember today as it was in 2004. Airbnb is a classic example of this scenario. The company's stock popped over 100% on the day of its IPO, and the firm's market value hit $100 billion. However, earlier this year, the company was in such a mess it borrowed $1 billion at a 12% rate of interest just to stay afloat. As part of this bailout, the private equity sponsors received share warrants that could be exercised at an $18 billion valuation. That was down from an internal valuation of $26 billion at the beginning of March 2020 and the company's valuation peak of $35 billion in 2019.

Based on these numbers, it is clear that Airbnb has been able to negotiate a higher valuation for itself than it would have otherwise been able to. This may or may not pay off for the company's investors, but what is clear is that the business was able to take advantage of investors' mood at the time. That's why IPOs should be viewed with caution.

Disclosure: The author owns shares in Berkshire Hathaway.

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This article first appeared on GuruFocus.