An initial public offering (IPO), the first sale of a company’s stock to the public, may make investors excited about the potential for growth as an early investor. But the research of University of Delaware finance professor Laura Casares Field presents a more complex image of IPOs.
“Prior research had shown that IPOs are generally not a good investment – on average, investors who purchase an IPO in the first few days of trading and hold the stock for three years will lose money,” Field said.
To better understand how and why this happens, Field’s team hypothesized that less sophisticated investors may be more likely to lose money when investing in IPOs. In a paper published in the Journal of Financial and Quantitative Analysis, Field and co-author Michelle Lowry described this research.
Working with data from more than 6,000 IPOs, Field and Lowry examined the holdings of institutional shareholders (like mutual funds and pension funds).
“We find that IPOs with the highest levels of institutional investment earn approximately 1 percent per month higher returns in the first year than IPOs with the lowest levels of institutional investment,” Field said.
This suggests that more sophisticated investors are able to identify the IPOs that will perform the best, and that individual investors bear the brunt of IPO underperformance.
“Moreover, we find that the reason individual investors do so badly when investing in IPOs is that they do not pay attention to firm fundamentals,” Field said. Institutional investors, she explained, tend to invest in higher quality IPO firms, while individual investors are more likely to invest in lower-quality firms, like younger firms with negative earnings.
Field and Lowry’s paper explained that IPOs that do not have institutional investors earn 16 percent less than similar firms after three years, while IPOs with institutional investors do not underperform. Additionally, 33 percent of IPO firms without institutional shareholders delist for poor performance within 5 years of the IPO, compared to only 13 percent for those with institutional holdings.
“Finally, we show that most firms lacking initial institutional interest fail to garner the interest of institutional investors even years later,” Field added.
So what lessons could investors take from research like this? The importance of informed research when making decisions, Field said.
“Our research suggests that the majority of the advantage institutional investors possess when investing in IPOs reflects their attention to publicly available information,” she explained. “Institutions are more likely to invest in the types of firms that tend to perform better, and they earn higher returns as a result. Individuals have access to the same information, but individuals appear to either disregard or misinterpret its relevance for firm value.”
“The lesson for investors of IPOs is to carefully review the offering prospectus and to do their homework before making the investment.”