Jay Ritter

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Jay Ritter is Cordell Professor of Finance at the Warrington College of Business Administration, University of Florida. He writes extensively for The Journal of Finance and other financial journals, and has contributed chapters on IPOs to several books, most recently, The Handbook of the Economics of Finance , published by North Holland.

IPOs

Buying at the IPO

'Increase the price, double my order. Decrease the price, cancel my order.'

When an initial public offering (IPO) is being sold, a price range is listed in the preliminary prospectus , such as $12-$14 per share. The day before trading starts, a final offer price is set. Sometimes, before the final price is set, the price range will be revised up or down. If the price is lowered , it indicates that the underwriter is having trouble finding buyers , and the stock is unlikely to jump at the opening. If the price is increased, this indicates that it is a hot issue, and the price is likely to jump at the opening. During 1990-1998, if the offer price was lowered, the average first-day return (from offer price to close) was 4%. If the price was increased, the average first-day return was 32%. With short- term profits in mind, you should ask for more shares the more the price has been increased. The reason that wanting to buy more, the higher the price, doesn't violate the laws of economics is that the price change is telling you about the state of demand.
IPOs are a marketing tool.

In recent years , IPOs have become a marketing tool. That is, with many IPOs jumping up to far above the offer price on the first day of trading, receiving shares has become a source of profits for investors. Brokerage firms reward their most profitable customers with IPOs. If you are a profitable customer, due to having a large account or being an active trader , don't be bashful about asking for IPOs. Brokerage firms know that they risk losing customers if they don't give their best customers hot IPOs. If you don't ask, you won't get the hot IPOs.
If a broker asks you to buy, stay away from the issue.

Unless you are a very profitable customer for a broker, if the broker offers shares in an IPO to you, it probably indicates that the broker is having trouble selling the issue. This is a bad sign.
Check out what the web sites are saying.

There are a number of web sites that cover IPOs, and give updated information on whether a given issue is hot or cold. These differ from chat rooms, where anyone can say anything that they want. Some of the web sites include www.ipohome.com (Renaissance Capital) and www.ipomonitor.com. Links to other websites can be found at my homepage (bear.cba.ufl.edu/ritter), at www.iporesources.org, and on Yahoo's IPO page.

Buying and Holding

Pay attention to valuation.

A great company doesn't necessarily make a great investment. In recent years many technology companies have gone public and subsequently grown rapidly . But if the stock price already reflects huge future profits, the upside potential is limited.

As an example, on October 22, 1999 a young company, Sycamore Networks, went public. Sycamore had $11 million in sales during the prior year, and at the end of the first day of trading had a market capitalization of $14 billion. The chance that Sycamore's sales and profits would grow to numbers that could justify this valuation is miniscule.

When Microsoft went public in March 1986, it already was profitable, it had $162 million in annual sales, and its market cap was only $700 million. At a valuation of $700 million, Microsoft had a lot of upside potential. At a valuation of $14 billion, Sycamore did not have a lot of upside potential, even if things went right. In mid-2001, the market cap of Sycamore was less than $2 billion.
The IPO market is never in equilibrium. It's either too hot or too cold. Buy in the cold periods.

Since 1990, the U.S. has averaged 35 IPOs per month. But this average masks considerable variation. There have been 44 months with at least 50 IPOs, and 15 months with fewer than 20 IPOs. Periods of low volume include the six months after Iraq invaded Kuwait in 1990, the six months after Long-Term Capital Management ran into trouble in 1998, and the six months after the collapse of internet stocks in late 2000. During these periods, the IPO market virtually shut down.

In general, the best time to buy IPOs for the long run is when the IPO market is in one of its cold periods, with low volume. One of the great all-time investments in a company going public was that of Cisco Systems, which went public in February 1990, a month when only 12 other firms went public in the U.S.

Research that I have conducted with Tim Loughran of the University of Notre Dame shows that since 1970, firms going public during low-volume periods have outperformed firms going public during high-volume periods, where the performance is measured from the close of trading on the first day of issue to five years later. Of the internet IPOs from 1999 and 2000, by April of 2001 97% were trading below their offer price, and 99% were trading below their first-day closing price.
Avoid young companies in hot industries.

Historically, in the five years after issuing, IPOs have underperformed the market. Measured from the closing market price on the first day of trading, IPOs have underperformed the broader market by about 4% per year during the five years after issuing. This underperformance starts six months after the IPO, and is most pronounced for young companies going public during hot IPO markets.

A contrarian strategy works best with IPOs: older, more established, firms in industries that aren't hot have historically produced the best long-run returns, especially if the offering is from a period when valuation levels are relatively conservative and few companies are going public.
Beware of the lockup period expiration.

When a firm goes public, the pre-issue shareholders commit to hold their shares for a set period of time, during which selling is prohibited without the express written consent of the lead underwriter. This period is typically 180 days. Around the time of the lockup period expiration, the stock price drops several percent, on average. The drop is even bigger for tech stocks.

Laura Field and Gordon Hanka, in an article published in the 2001 Journal of Finance , show that this drop occurs during the period from a week before to a week after the lockup expiration. If you are thinking of buying a stock which went public five months ago, it is best to wait for a little over six months before buying. But beware, because starting six months after the IPO is when the long-run underperformance starts.
Don't confuse growth with profitable growth.

A firm or industry can grow rapidly, but this doesn't necessarily mean that the profits will grow rapidly. If there are no barriers to entry, stockholders won't benefit from growth. As an example, the airline industry has grown from almost nothing to one of the biggest industries in the country, as measured by sales and employment. But the airline industry has never been very profitable. Competition from new entrants (almost all of whom have gone bankrupt) and higher labor costs from unionized pilots have kept profits down.

Even with rapid technological progress, a firm won't make large profits unless its competition doesn't have access to the technology. If all of the firms in an industry gain from new technology, competition drives down prices. Consumers benefit, but stockholders don't necessarily benefit. Managers sometimes lose sight of this and overinvest.
Evaluate the prospectus, focusing particularly on the management.

As explained in IPOs for Everyone by Linda Killian, Kathleen Smith, and William Smith of Renaissance Capital, evaluating management quality and incentives, and the company's fundamentals, helps to pick the good IPOs and avoid the bad ones. Checking management is especially important with IPOs where there is no venture capitalist involved. If management compensation is set up to enrich management whether or not shareholders do well, it is a warning sign. A board of directors that is dominated by insiders is a warning sign. If management has granted large numbers of options to themselves , this is another warning sign. If the earnings numbers are boosted by aggressive accounting procedures, this is another warning sign.

But nothing is foolproof. A company might have entrenched management but still do well. For many years, America Online (now part of AOL-TimeWarner) boosted earnings by aggressively booking revenue from future monthly fees. AOL's stock climbed as their market share expanded and they crushed the competition, and after a few years they changed their accounting policies.