IPOs (initial public offerings) and meme stocks are exciting news items that have garnered headlines in recent years. While investing in an IPO or a meme stock has the potential for investment returns under the right circumstances, many financial advisors would call these speculative investments and not a major source of revenue for cautious investors. Financial advisors frequently only discuss investing in IPOs with those clients that have a high risk tolerance and are seeking the chance to get in on the ground floor of an interesting new business, or a potential large payout.

Evaluating IPOs

Since IPOs can be volatile, brokerage firms set requirements for their investors to participate. The IPO could be limited to investors with a certain amount in their brokerage accounts or a minimum number of previous transactions to their name. Because companies issuing an IPO inform brokerages who then inform their investors, it is difficult to participate in an IPO without hiring a brokerage firm. That brokerage firms are so careful about which of their investors can join in an IPO should make it clear that IPOs are not for everybody. Financial advisors should thus take a similar stance and explain the risks of IPO investments to their clients.

Overvaluation is the primary risk. Companies launching an IPO are incentivized to maximize excitement for the day their stock first becomes available, and must strike a balance between creating public interest in their brand without over-inflating that interest to the point that the stock comes crashing down immediately. Unicorns and high-profile brands are especially vulnerable, as in the case of rideshare company Uber. Initially valued at $120 billion, their valuation dropped to $76 billion after one day of trading. Today, Uber is valued around $86 billion, a significant value differential from their launch. Undervaluations are often just as dangerous, meaning IPO investments generally have three results, only one of which, an accurate valuation, may be positive for the buyer.

When evaluating an IPO, investors should pay less attention to excitement and more attention to a company’s fundamentals, using both the company’s prospectus and information provided by a reputable third party whenever possible. Private companies are required to disclose all pertinent information before an IPO, but this data is still presented by the company in the best possible light, while a third party would be unbiased. Investors should also look at the company’s competitors, leadership, financing, and prior press releases, as well as the overall health of their industry. If hype and excitement are the noise about an IPO, then the state of the company and its field are the signal.

Stronger underwriters can indicate a stronger IPO. Quality brokerages, banks, funds, and venture capital firms have good track records of picking investments that may pay off. Underwriters are especially useful in this regard, as large and reputable companies like Goldman-Sachs can afford to be selective and make the sorts of well-reasoned, risk-averse choices individual investors should make. But even these institutions are not infallible and most have underwritten bad investments before, so their support is not a foolproof indicator of an IPO’s reliability.

Myth vs Reality

Like meme stocks, IPOs can spawn a “gold rush” effect where the popular perception is that anyone can invest in an upcoming IPO and make a fortune overnight. In reality, only very large investors are likely to a good allocation of IPO shares. Companies can assign their stock to brokerages as they choose, and tend to favor larger, more reliable organizations. Thus, only connected investors with strong brokerages are able to buy enough shares to significantly profit, even if the IPO holds its initial valuation or appreciates.

Ultimately, the numbers don’t lie – according to stockanalysis.com, as of September 30, 2021, there have been 771 IPOs on the US stock market in 2021, which is an all-time record. Of these, roughly 72% have lost value, and 17% have lost more than 15% of their initial value. Of course some IPOs have appreciated significantly, but the chance of an IPO investment paying off is small enough to make any wise investor cautious.

IPO Participation through Mutual Funds

The lead underwriters for IPOs generally allocate the vast majority of IPO shares to institutional investors, like pension funds and mutual funds, leaving only a small percentage for retail investors. However, many mutual funds have bylaws that prevent them from investing in IPOs until the stock has traded for more than six months. In addition, many funds tend to be conservative in their investment approach, focusing only on investing in companies with attractive valuations, conservative debt, and free cash flow – qualities lacking in many of these IPO companies. The best option may be investing in mutual funds that offer exposure to early-stage companies – including some IPOs – rather than focusing exclusively on them.

Ultimately, investors interested in a company launching an IPO should listen to their financial advisor on the risk suitability of such an investment. Every IPO is an unknown value and unknown values are by nature volatile. Most serious investment portfolios only set aside a very small allotment for IPO speculation. One look at the IPOs from 2021 alone should give readers a good idea of how unpredictably these stocks can vary. Of course, daring investors can do very well with a timely IPO transaction, but, without absolute confidence, investors should consider IPOs a risky proposition, do as much research as possible, and limit their risk with smaller buys.

Part 2 of this blog series will discuss meme stocks in greater detail.

Christopher Crawford is the Head of Sales & Marketing for the Buffalo Funds. He has over 10 years of experience in the financial services industry, previously holding positions at Invesco, IMA Financial Group, and Arthur J. Gallagher. At the Buffalo Funds, Christopher works with investment consultant relations, key account management, institutional distribution and client service. His main goal is to partner with advisors to bring business building ideas and provide unparalleled customer support to their business, always striving to make it easy and reliable to work with the entire Buffalo Funds investment team. Christopher received an M.B.A. from Washington University in St. Louis and a B.S.F.A. from Southern Methodist University. He also holds licenses for the Series 7, Series 63, and Series 65.

As of 6/30/21, Uber was 2.03% of the BUFMX portfolio; no fund held Goldman Sachs. Click here for links to each fund’s holdings. Fund holdings are subject to change and should not be considered a recommendation to buy or sell any security.