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Don’t let Snap fool you. IPOs aren’t must buys

Globe and Mail columnist David Berman.

The early success of Snap Inc. has a downside: It attracts us to new stocks, most of which are doomed to underperform over the next year or so.

That's not an easy statement to make, given what Snap – the company that owns the popular Snapchat app – has done since the company's initial public offering (IPO) last week.

On the first day of trading, the shares jumped 44 per cent, which is more than the S&P/TSX composite index has delivered over the past five years. Snap shares added another 10.7 per cent on Friday. They closed at $29.09 (U.S.), compared with an issue price of $17.

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Early investors made a killing and anyone jumping into the rally has done very well, too. That leaves risk-averse curmudgeons – myself among them – wondering if the next dividend payout on their index-tracking exchange-traded funds is a signal that they need to change their ways.

The short answer is no, even if Snap turns out to be a runaway success.

Academics have been crunching the returns on IPOs for decades, and have come to the conclusion that new issues tend to pop higher on their first day of trading but then underperform the broader market.

Jay Ritter, a finance professor at the Warrington College of Business at the University of Florida, explored this topic in a much-cited 1991 paper that looked at more than 1,500 U.S. IPOs between 1975 and 1984.

Mr. Ritter found that new stocks rose by an average of about 14 per cent on their first day of trading. Over the next three years, though, the new stocks delivered gains that were nearly half what their peers delivered.

"In the long run," he said, "IPOs underperformed."

Mr. Ritter continues to track the performance of IPOs, reflecting new industries and investing climates, but his conclusions haven't changed.

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In an interview on Friday, he said that Snap's first-day rally was unusually strong, but the stock falls into a pattern he has seen before: A money-losing company is difficult to value, the IPO is oversubscribed (meaning that demand for new shares outstrips the number of shares being issued) and investors hope for the best.

"An IPO should be viewed just like any other company," Mr. Ritter said. "A company like Snap might turn out to have a great future, but it might never make any money and the stock price might collapse."

Even if things go right, investors can be challenged early on. Facebook Inc. has been a huge long-term success, but the shares slumped more than 50 per cent in the three months following its IPO in 2012. It took about 18 months for the stock to return to its debut price of $38 (U.S.).

The Bloomberg IPO index, which tracks the performance of each new U.S. stock for one year, gives a broader perspective. The index has risen 43 per cent over the past year, to the end of February, which is nearly double the gain of the S&P 500 over the same period.

However, this looks as if it's a fluke, or perhaps bull-market euphoria: Over the past five- and 10-year periods, the S&P 500 has beaten the IPO index by a total of 26 percentage points and 22 percentage points, respectively.

IPOs tantalize us with the chance of investing in companies that still have tremendous growth prospects, but they can also tap into fads and market distortions, which can inflate expectations.

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Underwriters know this, which is why they often underprice new issues to attract more buyers. Nearly a week before Snap debuted, widely published reports suggested that the shares were oversubscribed, which all but ensured a strong first day of trading as investors piled on in a fervour.

What about gaining access to an IPO through your broker before the shares start trading? That can work in your favour, but only if the company is in high demand.

"Buying at the offer price exposes you to the risk that the broker will only give you shares in companies that other people don't want to buy," Mr. Ritter said.

He added: "It's a problem that both institutions and individuals face: The easier it is to get shares, the less you should want them."

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About the Author
Investing Reporter

David Berman has been writing about business and investing since 1995. He has written for a number of magazines, including Canadian Business and MoneySense. He worked at the Financial Post as an investing writer and daily columnist before moving to the Globe and Mail in 2008. More

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