You may have heard from news pundits or market veterans (I’ll lump myself with the latter) that the pool of available companies to invest in has been shrinking over the last 30 years. Many companies that would have gone public through an initial public offering (IPO) in the past have stayed private, longer. In turn, most of the appreciation in these stocks has been retained by the founders, employees, and private investors. So, what should we expect when these companies eventually go public? How does the market react and what does it mean for investors when these stocks finally come to market?
A Wave of New Offerings
Euphoria: The biggest offerings often come with the biggest fanfare. This is what the underwriters (big banks supporting the offering) are hoping to generate to make sure they can support the opening price. If done properly, they price the stock high enough to maximize proceeds to the owners. Remember, the IPO is the mechanism in which the company can raise money to grow the business, repay debt, or to generate money back to the original owners. On the flip side, they do not want it to be too high so that the stock price drops below the initial offering price, impacting both the underwriters’ and company’s ability to raise future capital.
Market Reaction: Expect volatility as the economic process of “price discovery” takes place. Over the following days, weeks, and months, the composition of investors will change.
Types Investors Participating in the IPO
Initial Sellers: these folks may own the IPO and are hoping to flip the stock for a quick profit. (Caution, flipping the stock in the immediate hours and even days can be viewed negatively by those same underwriters that need the price to be supportive. Thus, potentially leading to a restriction from future IPOs.)
Market Buyers: this type of investor may enter the market at different times for different reasons. Initial buying may be led by the FOMO crowd—AKA investors who were unable to get in on the IPO or did not receive the full allocation they wanted. Speculative traders (generally dependent upon heavy and volatile trading) may also try to take advantage of large intraday swings and huge volume will be active.
Long-term Investors: Through the normal investment process, long-term investors will start to take positions in these companies as well. This begins once IPOs start getting included in index funds, which depends upon their index mandate. Not all indexes will include these IPOs initially, and have varying rules as to both “when” and “how much” they should own. Professional traders working in this space will look to take advantage of the rules-based process of indexing.
Some indexes will begin to include stocks early on (i.e. the first few weeks of trading). Others like S&P may require the company to not only trade for as long as a year, but also meet requirements like consistent profitability.
The amount they allocate may not be based directly on the market cap (size of the company). In fact, most of the indexes will be “float-adjusted.” This means that the initial allocations may be very small based on how few tradeable shares are available. This can be less than 5% of the total shares due to lock-up provisions for founders, employers, and other early investors. It’s common for there to be a limited window for the pre-IPO investors to sell a small number of shares and then be free to sell all at a later date—typically 6 months after the IPO.
Post-IPO: What Does That Look Like?
Generally, there will continue to be an additional supply of stock coming to the market in the near future in amounts that may dwarf the initial offering amount. That additional supply can create an imbalance of sellers vs. ongoing buyers. It also increases the float leading to increasingly larger allocations to some of the index funds.
The Long-Run
The ultimate test will be the performance of the company over the long-run. As investors, we need to make sure we do not confuse the past astronomical wealth-generating success of these companies with their future prospects. Today’s investors are entering into a more established company with ambitious, but still relatively grounded (pun intended SpaceX investors) growth potential. The ability to risk investing in the company at a $1 billion valuation years ago and watch that investment grow 1,000 times to become a trillion dollar company is incredible, but to expect a repeat we would need for this to become the first quadrillion dollar company. Maybe we would settle for $100 trillion?
To Participate or Not?
Which brings us back to what most long-term investors should be thinking about. Is my financial plan dependent upon my IPO investing prowess? Ultimately, we will want to participate in the appreciation of these stocks as they are added to the investable universe. For most this will be through existing investments we have in ETFs which only requires patience. To be fair, varying levels depend upon the index.
The other is to make controlled investments as part of our diversified portfolio. If you do decide to invest in the excitement of these IPOs, just remember the risk and size appropriately.
