Investing in IPOs: What You Need to Know

This article is an excerpt from the Shortform book guide to "The Intelligent Investor" by Benjamin Graham. Shortform has the world's best summaries and analyses of books you should be reading.

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Is investing in IPOs a good idea? Should you invest in IPOs, and how do you know which ones are good investments?

Investing in IPOs isn’t recommended by Benjamin Graham in The Intelligent Investor. However, he adds that some IPOs are worth considering, and should be taken seriously.

So, should you invest in IPOs? Read to find out whether or not investing in IPOs is a good idea.

Investing in IPOs and New Stock Issues

In an initial public offering (IPO) or a new stock offering, privately owned companies “go public” and sell their stock to the public. This allows the company to sell their stock for cash, raising funds for further investment and allowing stockholders to cash out.

Not all new issues should categorically be dismissed when investing in IPOs, but they deserve extra scrutiny for two reasons:

The underwriters of the IPO (commonly investment banks) own a large portion of shares, so they have a passionate interest in painting the best picture of the company to pump up the price.
New issues are opportunistically sold under good market conditions (typically bullish), which means worse conditions for the buyer.

When considering investing in IPOs, we tend to fixate on the landmark examples of the past—the Microsofts and the Apples—while forgetting that most other IPOs were bad investments. Zweig notes that, between 1980 to 2001, if you had bought each IPO and kept it for 3 years, you would have underperformed the market by 23% annually.

The IPO Cycle

IPO hype occurs in a cycle. History has shown a regular cycle of 1) a bullish period, during which private companies go public with soaring stock prices, followed by 2) steep declines in a market contraction. This occurred in 1945, then in 1960, then in 1967, the dotcom boom in the late 1990s, and so on. Consider this when investing in IPOs.

In more detail, the bullish period has a repeatable sequence that brings stocks to unfathomable heights:

In the middle of the bull market, the first IPOs are priced reasonably, and its early buyers make large profits.
As the market continues to rise, more companies seek to cash out through IPOs, and the pace of new issues increases. At the same time, the quality of the companies going public deteriorates, and the prices soar to unreasonable heights.
During the bullish period, the fast rise of the new stock prices causes a greedy complacency that dulls the public’s critical skepticism.
A sign of the coming end of the bull market appears when the new IPO stocks are priced comparably to mid-sized companies with a much longer track record.
As the bull market turns downward, the new public stocks may lose 75% or more of their initial price.

For a notable example, AAA Enterprises IPO’d at $14 a share in 1968, reached a peak of $28, then dropped to $0.25 in 1971 (a 98% drop). (We’ll cover this company more in Chapter 17.)

An intelligent investor needs to maintain his critical faculties during bull markets and avoid buying overpriced shares that are far outside the underlying value of the business. If you’re patient, you can pick up steeply discounted shares just years later when the hot stocks fall out of fashion.

So, should you invest in IPOs? Maybe. Investing in IPOs is a challenge and you should only do so if you’re completely confident in your research and your investment.

Investing in IPOs: What You Need to Know