Last Updated May 19, 2011 4:39 PM EDT
An important myth that needs exposing is that IPOs make great investments. Wall Street loves IPOs because they generate great fee income. Investors seem to buy them with almost the same frenzy with which they buy lottery tickets as they desperately search for the next Microsoft (MSFT), AOL (AOL) or Cisco (CSCO). That may explain why LinkedIn's price jumped. Let's look at the reality of actual performance of IPOs.
University of Florida finance professor Jay Ritter looked at 1,006 IPOs that raised at least $20 million from 1988-1993. He found that the median IPO underperformed the Russell 3000 by 30 percent in the three years after going public. He also found that 46 percent of IPOs produced negative returns.
Another study examining the performance of 1993's IPOs through the period of mid-October 1998 found that the average IPO had returned just one-third as much as the S&P 500 Index. Amazingly, more than one-half were trading below their offering price, and one-third were down more than 50 percent!
A U.S. Bancorp Piper Jaffray study covering the period May 1988-July 1998 and 4,900 IPOs found that less than one-third were above their IPO price by July 1998. By comparison, the S&P 500 had a total return of 472% during the same period. In addition, "almost a third weren't even trading any longer (having gone bankrupt, been acquired or no longer trading in an active markets)."
A study covering the period 1988-1995 and 1,232 IPOs found very similarly disappointing results with 25 percent of all offerings actually closing the first day of trading below their offering price. The study also found that the IPOs defined as "extra hot," meaning they rose 60 percent or more on the first day of trading, were the very worst performers going forward-over the next year they underperformed the market by 2-3 percent per month.
1999 was a spectacular one for IPOs with 555 companies raising a record $73.6 billion. The amount raised surpassed the previous record, set in 1996, by almost 50 percent. For all IPOs, the median first day performance was 30 percent. However, investors who bought at the first day's closing price didn't do nearly as well. The median increase after three months was zero percent, meaning that half of all issues lost money. Even more amazing, nearly three-fourths of all U.S. Internet-related IPOs since mid-1995 were trading below their offering price at the time of publication.
In the face of this poor performance, why do investors continue to chase the latest IPO? I believe there are two explanations for this seemingly irrational behavior. First, unless an investor happens to read scholarly publications such as the Journal of Finance, he or she is unlikely to be aware of the facts. Second, even when informed, investors often act in what appear to be irrational ways. In this case I believe it to be another example of "the triumph of hope over experience." Investors seem to be willing to accept the high probability of low returns in exchange for the small chance of a home run or, possibly even more important, a great story to tell at the next cocktail party.
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