Just like a takeover, an IPO can be a powerful way to earn big gains in a single day.
In December of last year, for example, the average first-day return for all IPOs checked-in at an impressive 62.7%.
That’s all about to change, though. And it has nothing to do with the coronavirus.
Instead, it’s about the data.
You see, a bright red “Buyer Beware” sign is flashing right now. So if you’re considering any IPO investments this year, you need to pay attention…
Crash and Burn Rate: 70% to 80%
As I’ve written in these pages many times, share price is ultimately determined by fundamentals like earnings.
In fact, if you pull up a long-term stock chart of the S&P 500, and you plot it against S&P 500 companies’ earnings, you’ll see it’s an almost perfect correlation:
As earning rise, so do stock prices.
And actually, the performance of IPOs during the dot-com era proves the same point:
70% to 80% of companies that went public during that period were unprofitable — and 70% to 80% of those companies ended up crashing and burning.
Why bring this up now?
Because today, the percentage of unprofitable companies going public is even higher than 70% to 80%.
Take a look…
Record Territory — And It’s Bad
As you can see, we entered record territory in 2018…
More than 80% of the companies going public had negative earnings!
And since then, it’s only gotten worse.
This is one of the riskiest times in recent history to invest in IPOs.
So, before you decide to jump in, make sure to review these five hallmarks of a “worthy” IPO.
Five Hallmarks of a Worthy IPO
- Profitability. Unless a company is profitable (or on a clear path to profitability), avoid it. Otherwise, expect to lose a lot of money… just like investors lost money on Uber (UBER), Snap (SNAP) and Blue Apron (APRN).
- Annual revenue of $50 million or more. Research from University of Florida revealed that revenues are a strong predictor of stock performance. The key threshold is $50 million for the 12 months prior to an IPO. Companies below that level underperformed the market by ~15% for the next three years. And those above this threshold outperformed the market.
- Long-term growth potential. Next, invest in companies with long-term growth potential. That means addressable markets of at least $1 billion. This is easy to confirm: the addressable market is typically listed in the IPO prospectus under the heading, “Market, Industry and Other Data.” And if the company’s revenues are close to this number already, avoid the IPO. We want to buy future growth, not pay up for past growth.
- Insider ownership. Insider ownership is a good way to gauge if management’s interests are aligned with our interests. This figure is listed in the prospectus under the heading, “Principal and Selling Stakeholders.” If insiders retain at least 30% of the company post-IPO, the incentive exists to do exactly what we desire: increase share price.
- Offering size of $100 million or greater. This threshold weeds out the riskiest deals, and ensures there will be ample liquidity in the aftermarket. To calculate, multiple the number of shares being offered by the proposed pricing range. If you get a number less than $100 million, walk away.
In the End, Fundamentals Win
One final thing to keep in mind: IPOs are just like any other investment.
While hype might carry the day temporarily, share price is ultimately determined by fundamentals.
So, after you confirm the five characteristics of a worthy IPO, take some time to dissect the underlying business. The stronger the fundamentals, the greater your profit potential.
And if you don’t have the time for that, don’t worry…
I’ll be scouring the IPO pipeline this year to alert you to any low-risk, high-reward opportunities.