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So, IPOs Are Disappointing? What Else Is New?

Tanked offerings by Lyft, Blue Apron, and others are all too common. Historically, many companies going public have underperformed.

Art by Amy Matsushita-Beal

When Uber sells its stock to the public Friday, a lot of investment analysts are predicting this unicorn will stumble badly, as other highly touted debut stocks have done lately.

If so, don’t be surprised. Historical data shows that, for decades, a substantial chunk of initial public offerings (IPOs) of stock have underperformed the market. While they very often start out with a one-day pop, and may rise for a spell, a lot of them, sometimes a majority, eventually tend to lag.

That’s not to say that, as a group, they fall from their offering price and remain in the basement, although a number do. They overall averaged 21.1% returns over three years, according to data from Prof. Jay Ritter at the University of Florida, in his study of IPOs from 1980 through 2014. The problem is that they lagged the overall stock market by 17.8% When compared to companies of similar size, the IPOs trailed by 6.3%. In other words, investing in established publicly traded stocks offered better returns.

The post-IPO tumbles of many once-celebrated unicorns—startups valued at $1 billion or more—have been breathtaking. These pratfalls range from music streaming service Spotify (down 15.5% since its April 2018 offering) to social media network Snap (off 29%, March 2017) to meal-kit provider Blue Apron (dropping 90%, June 2017).

Why do so many stocks fade after their IPO launch? One big reason: The market wakes up the dispiriting reality that a lot of them don’t make any money. “The number of companies coming to the public markets with promises instead of profits has been increasing rapidly,” writes Blake Morgan, a noted market commentator, on the Seeking Alpha site.

Indeed, the number of IPOs in the red has exceeded 40% for every year of this century, through 2015, Ritter’s research indicates. And in 2014 and 2015, the share of unprofitable IPOs exceeded 70%.

In many cases, the stock slides demonstrate how the sparkling promise of a fledgling company can fade once a wide range of investors is able to pass judgment on the freshly public company. Reacting to the newcomers’ negative net incomes, these investors figure that the chances of a turnaround aren’t high. Why put money into a sinkhole?

Still, a dauntless contingent of IPO investors keep hanging on. That’s because the IPO hype factor is enormous, especially in a bull market, like now. Everyone wants to get in on the next Google or Apple. Solid market gains by such recent entrants as Pinterest, Zoom Video, and Beyond Meat give them heart.

“The excitement and lure of magic returns suck in otherwise rational folks,” writes Ken Fisher, executive chairman of Fisher Investments. “The party can last days, even weeks, as stories of quick gains attract suckers who hate missing out. But when it stops, the stocks often get clobbered.”

Does such a fate await Uber’s stock? In spite of scrappy competition from others, particularly Lyft, it continues to dominate ride-hailing. Under Uber’s new management, the company (founded: 2009) aims to be more than just a taxi substitute. It has delved into food delivery, scooter and bike rentals, freight hauling, and driverless cars—in a bid to become the Amazon of transportation.

To be sure, Amazon expanded from selling books online to purveying an enormous amount of consumer products—and spent a long time without profits as it plowed its proceeds into building out the business, which is now a powerhouse. The stock really accelerated five years ago, rising almost seven-fold.

Here’s the difference: Uber’s gushing red ink is far worse. Its negative earnings hit $3.7 billion in the 12 months through March. That is the biggest loss ever for a company in the year before its public offering, S&P Global Market Intelligence says. Compare the operating income of Uber and Amazon in the 10 years since their founding, using S&P data, and Uber’s losses dwarf those of Amazon (which toward the end of its first decade, had inched into the black).

IPOs issuance, strong last year, dropped in the first quarter, says Renaissance Capital, with only 18 deals and $4.7 billion raised, versus 44 offerings and $15.5 billion for 2018’s comparable period. But the recent falloff may be a function of the pre-Christmas market dive, and Renaissance Capital anticipates a pickup in the current quarter. Waiting in the wings are much-anticipated IPOs from room renter Airbnb, workplace messaging service Slack, trading platform Robinhood, and mattress maker Casper.

The promise of getting in on a perpetual motion machine that churns out growth from day one is the attraction of IPOs. Everyone has heard about the Microsoft Millionaires who were in on its 1986 IPO, when even secretaries at the software and (now) cloud colossus benefited.  A lot of non-employee investors who got in on Microsoft at the outset amassed huge wealth, as well.

Sometimes, an early IPO investment is a bonanza coming out of the gate. Google, now known as Alphabet, went public in 2004, and had a respectable first day, up 18%. Buoying it was that the search company sported expanding profit and revenue. Then the stock really took off, as Google elbowed aside the likes of Yahoo’s search engine and became an advertising magnet. If you invested at the going-public date, your stock increased nearly 28-fold in the 15 years since, split-adjusted.

Other times, an IPO seems to be a bust, but then turns around. Facebook was a celebrated newcomer in May 2012, when it went public, and profitable to boot. A series of glitches at Nasdaq, however, prevented investors from getting their shares or made them pay more than they had bid. Lawsuits multiplied. CEO Mark Zuckerberg didn’t help matters by skipping a road show presentation. Over the next few months, the stock dipped from its $38 opening price to $18 in September of that year.

Nevertheless, the social network got its mojo back and hit a high of $208 last summer. While a series of misadventures in recent months over privacy and inappropriate content have pushed Facebook shares down some, it still changes hands at more than five times what it launched at.

Just the same, the reasons to be chary of investing in a newly public company, and waiting until it proves itself after a few years of public trading, are stark. “The companies’ and buyers’ incentives aren’t aligned,” asset manager Fisher writes. “An IPO has two main purposes: raising money and giving early backers a big payday. That requires a high price—too high, usually, to be priced well for buyers.”

Here are the standard weaknesses of IPOs, which weigh on their performance:

Earnings woes. The all-time prize for shoddy wares coming to market, naturally, goes to the dot-com darlings that went public in the 1990s. The vast bulk of them were blissfully free from earnings, let alone viable business plans. Food delivery service Webvan, for instance, was a pioneer in the then-novel practice of taking orders online and lost tons of money.

Webvan did an IPO in 1999 and raised $375 million, which put its market value at $4.8 billion. Trouble was, the company burned through its capital due to money-wasting tactics like building its own warehouses. Despite backing from heavyweights like Sequoia Capital and Goldman Sachs’ venture arm, the company declared bankruptcy and shut down in 2001. (GrubHub, a successor, had a well-received IPO in 2014, and its share price is up 100%.)

Fast-forward to 2019, and Lyft, which had a lot going for it. The ride-hailing service has poached market share from Uber, and expanded revenue. It has positioned itself as a more socially conscious company than Uber, which is trying to shake off the bad publicity attached to former CEO Travis Kalanick, under whose leadership sexual harassment and other charges were rife. Despite its pluses, Lyft’s losses have widened to $911 million last year from $688 million in 2017.

No wonder that, after a first day 8.7% rise in its late-March debut, it has lost one-fifth of its value. In fairness, fledgling companies often need to forego profits and plow the money back into growing the business. Prime example: Amazon. Investors, though, have to steel themselves for more rocky times ahead with Lyft. 

Unequal share classes. All too often, companies will go public with a class of super-voting shares for the founders and other insiders. This permits them to retain control of the company and gives them an advantage when swatting away pesky activist investors. Yet it also can produce bad management decisions that don’t help the stock.

Consider Lyft founders  John Zimmer and Logan Green, who, according to the company’s prospectus, own a mere 5% of the stock yet control 49% of the votes. Add in the directors and officers, and the insiders are sitting on 61% of the votes. 

This is an old problem. Sergey Brin and Larry Page, the founders of Google, keep voting control of parent company Alphabet thanks to a structure that grants them 10 votes per share, while other investors get one vote or none, depending on the class. Facebook CEO Mark Zuckerberg holds about 60% of the votes even though he has only a 14% stake in the company.

Some 15% of the companies that went public in 2017 and 2018 have such multiple share classes that grant unequal voting rights to insiders, by the Council of Institutional Investors’ count.  Last fall, the group petitioned the New York Stock Exchange and Nasdaq to limit the listings of companies with dual-class structures,

“While some companies that are controlled by virtue of special voting rights function as benevolent dictatorships, we have seen others stumble because of self-dealing, lack of strategic planning, and ineffective boards,” said Ash Williams, the council’s chair and also executive director and CIO of the $202.8 billion Florida State Board of Administration. 

Underpricing. It’s an old trick: Hoping for the usual pop at the offering date, early investors ensure that the opening price is on the low side of the valuation spectrum (albeit hardly a bargain). They got in for very little, of course. True, founders, employees, and other insiders often can’t sell their holdings for three to six months, known as the lockup period, so the bet is that the excitement continues.

But the big investors who get in at the opening often have nothing barring them from selling soon after the initial surge. As David Chambers, an IPO historian at Cambridge Judge Business School, told blogger Robin Powell, “IPOs are underpriced just about everywhere.”

Twitter caught a lot of flak for underpricing its offering in 2013. By some reckonings, it made $2 billion from the sale and left another $1 billion on the table. On the first day, the stock soared 73%. It peaked at $69 one month later, and has ebbed ever since, now trading at around $41.

Twitter’s longtime profit-free status had a lot to do with this (although it edged into the black last year). The company has said that the offering price was kept low because it didn’t want to replicate Facebook’s messy IPO.

Benjamin Graham, in his iconic book “The Intelligent Investor,” wrote that “most new issues are sold under ‘favorable market conditions’—which means favorable for the seller and consequently less favorable for the buyer.”

While that sounds overly harsh (and in the case of win-win situations such as Microsoft, isn’t necessarily so), the overall track record of IPOs suggests caution.

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