The Snap Inc. (NYSE:SNAP) IPO happened last week, giving millennials yet another reason to prove to older generations that they will forever doom our planet to a premature death, probably from explosion. They delivered, snatching up shares with all the gusto of me buying up North Korean currency.
What? You gotta admit that country only has one direction to go. Nukes!
The issue was supposed to debut at $17 per share, but strong interest before the open shot shares up to $24 before the first trade was made official. It went all the way up to $29.24 during trading the next day before falling faster than my chances to make friends with the rest of the PF blog-o-net. Shares trade hands for $22.71 as a write this, a major bummer for anyone who bought during those first couple of days.
Snap’s IPO wasn’t the only one to go nuts over the first little while and then fall below their issue price. The Facebook IPO popped during the first few hours of trading before retreating quickly.
Twitter exploded higher after its late-2013 IPO. By May, 2014, it was trading under the issue price.
LendingClub soared after its December, 2014, IPO. Just over two years later shares are down 78%.
Not every big IPO has been a disaster, of course. Long-term investors who bought Facebook during its first day of trading don’t regret the decision. The Alibaba IPO went relatively well, too. And Shopify is up about a million percent since its 2015 IPO. That math is 100% right. No reason to check it.
Still, buying the latest IPO is a pretty bad idea. Here’s why.
The logistics of IPOs
Basically, an IPO works like this. A company decides it wants to go public, usually for one (or more) of the following reasons:
- Prestige of trading on a major stock exchange
- The chance for employees to cash out stock
- Pressure from investment bankers looking to make a buck
- Easier to raise money in the future
- Valuation gap between public and private investment money (i.e. retail investors giving it a richer valuation because they’re suckers)
A company wishing to go public will contact several investment bankers and ask them to draw up some sort of plan. They’ll discuss logistics like the size of the deal, the potential offer price, and so on.
Once the company picks one or two underwriters to work with, it’ll start discussing the real details of the deal. Say a company wants to raise $100 million, consisting of 10 million shares at $10 each. The underwriters will then ask for a bonus allotment, which they’ll exercise if the deal goes well.
The company then gets to work on its prospectus, which is a long and boring document investors are supposed to read before they plunk money down. Spoiler alert: they never do. The prospectus is half sales copy and half risk factors, and is designed to give investors an idea of what they’re buying. It’s a lot like an annual report.
Up next is the road show, where the underwriters and company management go and sell the deal to potential investors. It’s usually only big investors who are invited to such a thing. The road show will last 10 days or so, and hit every major market. Depending on the size of the deal, they might even make a stop in Europe or Asia. OOOH EXOTIC.
After speaking to investors on the road show, the underwriters decide where to price the deal. Say demand for my imaginary IPO is strong. They’ll come back and recommend a price of $11 or $12 per share. The opposite happens if demand is weak. Remember, the underwriters want to under price the IPO so it pops on its first day of trading.
Finally, the big day comes. Demand usually outweighs supply, so it takes the stock exchange anywhere from a few minutes to over an hour to start matching up buy and sell orders. If the stock is up, the underwriter will exercise their bonus allotment. If the stock is up, usually everyone is pretty happy.
What happens after the IPO?
Study after study have looked at IPOs a year or two after they debut on the stock market, and they all say pretty much the same thing. On average, IPOs underperform. You’d be better off to buy a boring ol’ index.
The reason for this is pretty simple if you think aboot it. When the underwriter does their job, they’re creating a huge demand for shares. The IPO usually represents peak demand.
A few months after the IPO, the same investment banker will often quietly arrange a secondary offering, which usually allows more insiders the chance to cash out. This will also help push the share price down.
Investors who get a piece of an IPO aren’t stupid, either. They usually only hold for a few hours, flipping their shares to some other sucker amid the frenzied first day. If the IPO is hot, CNBC or BNN will cover the hell out of it. This attracts retail investors. The cycle completes itself a few months later when they get bored and sell.
The Snap IPO is the perfect example. It’s more overvalued than popcorn at the movies. Eventually the people buying shares will sit down and realize that.
The bottom line? Just avoid IPOs. At a minimum, give any new shares six months before taking a look, just to let the dust settle.