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Do IPO stocks usually rise on the first day of trading? Should you hold IPO stocks?

Should you buy a stock on the first day of trading? Should you hold such stocks?


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Image representing ipo pop, 1st day ipo gains

New issues and IPOs are fairly common around the world. At a specific stage of establishment, companies may desire to offer their shares in primary markets to raise capital, and strengthen their financial position, etc.


However, investors and traders may be interested in a short-term trade in IPO stocks. This report examines whether buying IPO stocks is a good strategy for a short-term allocation/trade. The question of whether IPOs rise in the first day(s) of trading is addressed in this report. The report utilizes empirical evidence for definitive answers and broader general conclusions.


Does the nature of IPOs make them a good short-term investment?

For a higher expression of interest by investors, and to secure adequate levels of subscriptions of the new issue, the underwriters of the issue (investment banks), who are tasked with selling the new issue of shares of the company, through book building, choose a low price to attract more investors and ensure that book-building, securing subscribers for the new issue, isn't a problematic task for them.


They guarantee the sale of stocks of the companies they assist in this process and hold shares that they cannot sell to external investors. A financially burdening condition, indeed. Hence, they generally sell such offerings at a discount to ensure full subscription.


By doing so, the investment bank ensures that it wouldn't have to hold a high level of unsold shares. If the bank is responsible for making the market (providing liquidity for the issue) and initially supporting the price of the shares in the secondary markets, months after the issue, a low price and full subscription ensures that the underwriter does not have to hold shares or initially support then if the price falls (due to being perceived as overpriced).


Essentially, this measure ensures a lower possibility of the bank being financially burdened.

The underwriter also benefits by a low price by allocating valuable shares to its clients so that they can benefit, as through such allocation, the underwriter benefits, in turn, indirectly. This objective, of course, cannot be accomplished with a high issue price.


"First-time issuers also accept a slightly lower price because if the offering is priced high, and the new issue is undersubscribed, it sends negative information to the market about the company and its future prospects. If the issue is priced lower and the share price rises in the secondary markets, the firm's management, business model, and future prospects may be viewed favorably. Appreciation of share price may also directly benefit management, as they may be awarded significant performance benefits etc., and receive recognition regarding their efficient performance by peers/analysts outside the business."


Combined, all factors mentioned above, usually tend to lower initial offering prices; prices are often expected to rise in secondary markets following an IPO due to the factors explained in this section. Therefore, many market participants see a short-term IPO trade favorably.


Does empirical evidence support this view? Do IPO-stocks rise on the first day(s) of trading?

Many empirical studies have been conducted on this topic, most notably, scholarly work by Prof. Jay R. Ritter of the University of Florida, Warrington College of Business, provides valuable insights on this topic.


An analysis of 4 decades of data, for time series 1960-2011 revealed that the price of IPO stocks at the closing of the first day of trading was 17% higher (Ritter, 2021).


Our analysis of 3,632 IPOs from the last 2 decades, 2000-2020, revealed that on average, IPO-stocks rose by 13.6% on the first day of trading. Furthermore, calculation of the mean confidence interval revealed a 95% confidence interval range of 13%-15%.


This means that as per the data from the last 2 decades (examination of 3,632 IPOs), we can logically expect an IPO-stock to rise in the range of 13% to 15% on the first day of trading, 95% of the time. This also means that an "IPO-POP" should be expected to be in the range of 13-15%, as per the data from the last 2 decades.


Many offerings have significantly overperformed this range in the data (top 15 performers 2000-2020):

Source: IPOscoop

The ten biggest 1st day increases: 1. the Va Linux 12/09/99 697.50%, 2. Globe.com 11/13/98 606%, 3. Foundry Networks 9/28/99 525%, 4. Webmethods 2/11/00 507.50%, 5. Free Markets 12/10/99 483.33%, 6. Cobalt Networks 11/05/99 482%, 7. MarketWatch.com 1/15/99 474%, 8. Akamai Technologies 10/29/99 458%, 9. Cacheflow 11/19/99 426.56%, 10. Sycamore Networks 10/22/99 386% (Ritter, 2021).


Others have significantly under-performed expectations (top 15 worst-performers 2000-2020):

Source: IPOscoop


Are initial public offerings a good short-term investment then?

While data does support that these stocks are highly likely to rise on the first day of trading, short-term investment, i.e., investing in such stocks for a few months, or investing in an IPOETF is a different story.


Our report on investing in IPOETFs evaluates ETF options in the space (see full report for in-depth analysis)


Subscribing to an issue for a 'first-day pop' may not be as simple as it may appear at first. Offerings that are valued 'conservatively' by the underwriter or for stocks that, due to firm performance, brand value, etc., are expected to 'pop,' may be hard to acquire. Such stocks are often in short supply due to high demand, thus, allocations of such stocks may be rationed for each investor/investment entity.


Subscribers of the issue often are also subject to 180 days lock-up period, i.e., they cannot sell their shares before 180 days have passed. Nonetheless, if a trader can acquire a new issue (stocks) of a company which her analysis does reveal is underpriced, i.e., the fundamentals of the firm are strong, and demand is likely to be high, right after the trading bell ring, it is likely that she would make a profit of 13-15% on the first day of trading.


But it is more likely that demand for such shares is going to exceed supply, and based on the applied order precedence hierarchy of the exchange, i.e., which orders go first, she may not be able to acquire a substantial number of shares to make significant profits. A rationing system may also be applied that prevents individual investors from acquiring more than a certain number of shares.


However, if an investor blindly tries to acquire all new issues without analyzing the fundamentals, then more often than not, she would acquire shares that are less demanded by the market. As explained above, acquiring in-demand shares may be difficult, but acquiring shares that aren't highly demanded by other investors would be much easier. Thus, she would be acquiring more shares with low demand and fewer shares with a high demand; hence, she wouldn't be able to make the expected profits of 13-15% on the first day of trading.


This, a form of adverse selection, due to the above-explained causes, can also be referred to as the winner's curse: You "win" (get all the shares you requested) when demand for the shares by others is low, and the IPO is more likely to perform poorly, but you don't win when the demand is expected to be high (Rock, 1986; Levis, 1990).

Is it wise to hold IPO stocks for a few years?

While stocks usually perform well immediately after trading, holding these stocks isn't ideal as per empirical evidence. One important factor is cyclicality (explained in this report).


"Prof. Ritter found that newly listed firms subsequently appear to perform relatively poorly over the following three to five years after their IPOs (Ritter, 1991). Brav et al. (2000), in their study titled "Is the abnormal return following equity issuances anomalous," found that between 1975 and 1992, IPOs underperformed the S&P 500 by 44%; Jay Ritter & Ivo Welch (2002), found that between 1980 and 2001, such stocks underperformed the market by 23.4%, on average. Therefore, as per empirical evidence, holding such stocks may not be logical; new stock issues of companies, as per empirical evidence, generally decline in the years after the IPO (Ritter, 1991).


Therefore, in conclusion, while buying an initial public offering of a stock may yield good short-term profits, such stocks do not perform well 3-5 years after the issue, as per empirical evidence.



References

Brav, A., Geczy, C., & Gompers, P. A. (2000). Is the abnormal return following equity issuances anomalous?. Journal of financial economics, 56(2), 209-249.


Levis, M. (1990). The winner's curse problem, interest costs and the underpricing of initial public offerings. The Economic Journal, 100(399), 76-89.


Ritter, J. R., & Welch, I. (2002). A review of IPO activity, pricing, and allocations. The journal of Finance, 57(4), 1795-1828.


Ritter, J. (2021). IPO Data. University of Florida Warrington College of Business. Retrieved from https://site.warrington.ufl.edu/ritter/ipo-data/


Ritter, J. R. (1991). The long‐run performance of initial public offerings. The journal of finance, 46(1), 3-27.


Rock, K. (1986). Why new issues are underpriced. Journal of financial economics, 15(1-2), 187-212.


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