BEWARE: This is the Biggest Scam on the Market Today…

There’s nothing in the investment world that’s quite as exciting as an initial public offering.

An IPO is the event that transitions a company from being privately owned to becoming a publicly-traded stock that you and I can buy. It’s the thing that makes a hot startup like Snap, Facebook, or Tesla Motors something that you can actually buy.

That’s exciting! But the actual event is a big deal too.

Management lines up on stage at the stock exchange, and the CEO gets to hit a big red button to symbolically ring the opening bell. There’s confetti. People cheer.

It’s a celebration!

And maybe that’s why it’s so dangerous for investors to put their money into new IPOs…

When you need confetti and music to convince investors to buy something, maybe they shouldn’t be buying it.

At least that’s what the performance numbers show.

“According to research done by Wharton professor Jeremy Siegel, a portfolio that bought equal dollar amounts of every IPO each year from 1968 through 2003, would actually have posted worse performance than a portfolio of existing small-cap stocks,” our stat man Jonas Elmerraji explains. “For every Facebook and Tesla, there are scores of underperformers and IPO horror stories.”

Why doesn’t buying new IPOs make a sound investment strategy?

It’s because what the investment banks are selling when they take a new stock public isn’t the same thing as what investors think they’re buying…

“Most investors think they’re buying at the ground floor when they buy shares of a hot new IPO. They think that they’re getting the chance to get into the next Apple or Microsoft from day one,” Jonas says. “Thing is, when you buy a new IPO, you’re not buying at the ground floor at all. Instead, you’re buying at the top floor, hoping that the company keeps on building new floors above you.”

The ground floor is where the founders, early employees, and venture capital investors get in. By the time a company is big enough to go public, the ground floor is a distant memory.

What many investors don’t realize is that, for early-stage venture capital investors, the IPO is the opportunity to exit an investment that’s already been successful. In fact, venture funds literally refer to their portfolio companies going public as an exit. The two words are synonymous.

Unless they’re contractually or legally required to, these early-stage investors don’t keep holding onto shares once individual investors can buy it.

There’s a very good reason for that, even in the hottest, most in-demand stocks. According to research published in Barron’s by investment management firm Gerstein Fisher, “While first day returns for Hot Issue IPOs are quite high, they are unlikely to be achievable for investors because they are unable to get the shares they indicated for due to oversubscription. Additionally, IPOs historically have underperformed for up to two and a half years after going public.”

Hmmm. Big first day returns followed by the price action fizzling out?

Sounds a lot like Snap Inc. (NYSE:SNAP), a stock that exploded out of the gate this year, only to retreat 26% off its highs at the beginning of March… so far.

That’s not a recent phenomenon – a 2014 study by investment company Betterment found that the median IPO underperformed the broad market by 16% after taxes in the three years following going public.

“It’s no wonder the ‘smart money’ gets out when a company goes public. The Facebooks and Teslas of the world are the exceptions, not the rule,” Jonas explains. “Case in point: the medium performance from a stock that’s gone public in the last 12 months has been -2%. And that number is frankly a little overly optimistic, since it assumes that investors were lucky enough to get in at the initial offer price. I think you get the idea – buying brand new IPOs is bad.”

But buying not-so-new IPOs? That’s a different story.

When it comes to IPO investing, the trend is your friend.

I mentioned a moment ago that IPO examples like Facebook, Tesla, Microsoft, and Apple were the exception, not the rule. So, what’s the one thing all of those examples had in common? They all began trending higher early on.

“Remember, the price action tells an important story – actually, it tells the most important story,” Jonas concludes. “If a post-IPO stock is moving up and to the right, we’ve got all the evidence we need that buyers are back in control of things.”

It’s still far too early to tell which way the trend is moving on anything that’s gone public in 2017. While new IPOs are accelerating, the smartest move you can make is to sit on your hands and focus on the established trends elsewhere.

Sincerely,

Greg Guenthner
for The Daily Reckoning

The Daily Reckoning