The safest way to profit from IPOs

In the spring of 1999, the Australian Government sold the second tranche of its Telstra (ASX: TLS) stock at $7.40 a share. It was the largest Initial Public Offering (IPO) in Australian history. Over the following two months, the media fell in love with the stock: anything related to the internet was exciting at the time, and here was a telecom monopoly. The share price shot up 20%.

Everyone loves to make a quick buck and for those investors who bought into the Telstra IPO - and quickly sold after it listed - their wish came true. These so-called 'stag profits' look easy, and there's no shortage of commentators in stock forums boasting of the quick money to be made in the latest hot IPO. 

The trouble, however, is that short-term IPO profits are usually based on the hope that someone else will pay more for the stock than you did. That's no way to invest for the long term: let's not forget that Telstra's share price is less than half its Tranche 2 listing price some 20 years later. It never beat the high-water mark set just after listing.

In fact, this is a familiar story for IPOs. Of the 99 companies that listed on the ASX in 2018, the average first-day return was 9.4%. But the months that followed were unkind: 70 out of 99 are now trading below their issue price, with the average return to date being a loss of 9.7% despite the All Ordinaries index being just a couple of per cent away from a 10-year high. 

The volatility of the market and economy will inevitably impact an IPO's share price after listing. But there's a deeper reason that most IPOs fail to live up to expectations: the process of listing a stock is significantly biased towards enriching the sellers, not new investors. 

How to rig a market

Warren Buffett put it this way: 'An IPO is like a negotiated transaction. The seller chooses when to come public - and it's unlikely to be a time that's favourable to you.'

Listing a company is a lot like selling a house. The seller is generally at an advantage because they know every broken step and leaky pipe. The seller has all the inside information, and it's in their financial interest to get the highest sale price - not to tell you that the freshly painted walls are actually to cover up a serious mould problem. Likewise, sellers of a company tend to do everything possible to juice up short-term profits just prior to listing, even when it disadvantages the company over the long term. If you want a detailed recipe of how it's done, there's no finer example than Dick Smith's blow up.  

Many mum and dad investors don't realise that the issue price isn't determined by the market, but rather is decided by the investment bank working for the company being sold - the same investment bank that typically gives its institutional and high net worth clients first dibs on buying shares. 

Institutional clients, pension funds, mutual funds and the like are an investment bank's VIP customers. The bank wants them to turn a profit and for the stock to shoot up after listing. To do this, it hits the airwaves with all the public relations, news articles, interviews and investor presentations it can muster. The goal is simple: media hype.

Remember, the seller is choosing when to sell, which almost inevitably means rosy industry conditions and sugar-coated accounting. The news is overwhelmingly positive in the lead up to an IPO, but the general public hasn't had a chance to buy yet - so dozens of cognitive biases fire up, such as a fear of missing out, confirmation bias, and herd mentality. Investors jump on the stock as soon as it lists.

All these factors combine to ensure that IPO's are more likely than not overvalued. I know, I know. Google, Amazon, Sydney Airport (ASX: SYD) and CSL (ASX: CSL) all lived up to the hype and generated long-term value for their early investors. But these companies are the exception. A University of Florida study found that between 1980 and 2016, IPOs underperformed the market by an average of 3.3% a year in the five years after listing. 

The irony is that plenty of IPOs are actually good businesses with decent growth prospects. The problem isn't that newly listed companies are of lower quality - it's that investors pay too much. That being the case, there's one crystal clear way for you to profit from IPOs: value the business conservatively, don't speculate on short-term price movements, and patiently wait until the market offers you the stock at a sensible price.