Is investing in an initial public offering (IPO) right for me?

There are a number of rumoured UK initial public offerings (IPOs) planned for 2020 and beyond. Darktrace, a cybersecurity startup, let its investors know last year that an IPO was its goal. Film buffs might like the idea of acquiring shares in Vue Cinemas and its 200 screen worldwide if it goes public. McLaren’s CEO has expressed a desire to take the company public.

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Being among the first shareholders in a hot, newly public company and potentially making a mint has an undeniable allure. Some IPOs have indeed made shareholders incredibly wealthy, but many others have left investors with nothing. On average, IPO investors could have probably done better.

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What Jay R. Ritter found in his study of 1,526 IPOs from 1975 to 1984 was that a strategy of investing at the end of the first day of trading and holding for three years was inferior to investing in matching firms that were already listed. The IPO investors ended up with 83p relative to each £1 invested in the comparable firms.

Ritter identified over-optimism in the prospects of the debutant firms as the chief cause of the underperformance in IPO investing, particularly when there are many IPOs happening in the latest hot topic – think companies at the turn of the millennium, or ride-hailing apps now. Investors end up paying too high a price.

Maybe it’s the fear of missing out on the next big thing that makes any price seem like the right price for IPO investors, or perhaps it’s because the price was never right to begin with.

Making it public

There are more rules and requirements to comply with as a public company compared to a private one, and more people to keep happy. So, why would a company go public?

Access to public markets for capital to expand is a good reason. Introducing the company to new customers through the publicity of the IPO process and a listing on an exchange is another.

New rules for IPOs were established in July 2018. Potential investors now get to see an FCA-approved prospectus before any research from banks that are involved in the actual IPO. Those banks also have to allow unconnected researchers the same level of access to information that their in-house research teams get.

Investors need to be cynical when reviewing material published by the company and its backers. Naturally, the company will present as rosy a picture of its prospects as possible because it wants to sell for as much as possible. Well-informed independent research will provide balance, but investors still need to do their homework.

Perhaps a private equity firm has squeezed every last drop out of the company’s margins and wants to cash in now. Only careful scrutiny of the financial performance might reveal darker motivations for going public. Keep in mind that companies going for IPOs are typically younger and have short track records.

Are IPOs right for me?

Investing in IPOs is riskier than investing in the market in general. An investor looking for growth would probably be better off investing in existing growth companies. For income investors, IPO investing will rarely make sense.

Any amounts committed to IPOs should be small, and you should be able to lose your stake without it affecting your long-term investing goals.

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James J. McCombie has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.

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