Investors should steer clear of recently listed stocks as a general rule, according to Dimensional’s Philipp Meyer-Brauns, who points to research showing they tend to significantly underperform the market in the year after their flotation.
Moonpig and Dr Martens are two examples of high-profile initial public offerings (IPOs) that have already taken place in the UK this year. Meanwhile, Deliveroo announced last week that it expects its flotation to value the company at £8.8bn, which would make it the biggest in the UK since Glencore almost a decade ago.
Performance of stock since IPO
Source: FE Analytics
And it is not just the flurry of headlines around stock market flotations that pique investors’ interest, according to Dimensional.
“IPOs are commonly associated with outsized stock returns on the first day shares become available,” said a statement from the group.
“[Jay R Ritter’s paper ‘Initial Public Offerings: Underpricing’] shows initial trading prices typically exceed the IPO offering price, and the author documents an average first-day return of 17.9 per cent from 1980 to 2018.
“However, accessing these first-day returns requires an allocation from the underwriting banks.
“Studies have documented an adverse selection problem associated with IPOs: those with poor first-day returns have generally been easier to obtain in advance, while those with good first-day returns have usually been reserved for certain clients of the underwriting banks.
“[Therefore] these returns may not be attainable by all investors.”
Many retail investors who fail to buy in to a stock at IPO may be tempted to get in on the action once the stock has listed. However, Meyer-Brauns, who is head of investment solutions analytics at Dimensional, said the company has conducted research suggesting they may be better off looking elsewhere.
“What we find is that the initial ‘pop’ that generates a lot of the attention is not necessarily something that stays over the first year,” he explained.
“So, those who missed out on the first day of trading would have missed the peak window altogether.”
Dimensional studied the returns of more than 6,000 US IPOs from 1991 to 2018, arriving at two important conclusions.
First, it found that in the year following their first full day of trading, newly listed stocks made an average gain of 6.93 per cent, compared with 9.13 per cent from the Russell 3000. Second, they were almost twice as volatile, with a score of 27.62 per cent compared with 14.28 per cent from the wider market.
Return and volatility of stocks
Source: Dimensional
“So, much lower returns and much higher volatility, which leads us to conclude that overall, the hype is probably not something that investors should buy into,” Meyer-Brauns continued.
“In our view, as far as the data tells you, there is no need to rush into the latest hot IPO. We liken it to purchasing a fancy new car, or luxury item, where it may be tempting to get it as soon as possible, but the odds are that buyer's remorse may set in over the first year or so.”
So why do these stocks underperform to such an extent after their IPO? Meyer-Brauns said there are technical reasons: lockups, which prevent the underwriting banks from immediately liquidating their positions on flotation, typically expire between six and 12 months after listing. These banks tend to account for a large proportion of shares and giving them the green light to sell can put downward pressure on the stocks.
However, he pointed out recently listed stocks tend to share other characteristics – high valuations with low or zero profitability.
“That group of stocks for a long time has been known to have relatively low average returns, so it fits right in,” he added.
Meyer-Brauns said there is nothing wrong with IPOs as a concept, adding that they perform an important role in giving companies access to public capital. However, in terms of investment performance, he said there is little to lose from waiting six to 12 months for the hype and headlines to fizzle out.
“If you're a well-diversified long-term investor with lots of stocks in your portfolio, there's really no reason to rush into these IPOs, and the data bears that out,” he continued. “If anything, you're doing that at your own peril.
“For us, it's very clear that it is right to wait a little bit until the market can bring its pricing power to bear and do its work in terms of appropriately valuing the security that just got listed.
“As with many topics, it's always easy to fall for the hype without taking a step back and looking at the broader mass of data.”
The UK Listing Review, published on 3 March, recommended a series of reforms to the rules that govern how companies raise finance on public markets. These include reducing free float requirements – the amount of a company’s shares that are in public hands – from 25 to 15 per cent; and modernising listing rules to allow dual-class share structures, giving directors enhanced voting rights on certain decisions.