Why investors shouldn’t rush to buy the next blockbuster IPO

Initial public offerings (IPOs) attract significant investor interest, yet a close examination of historical data and research indicates that they should be approached with caution. Examining decades of empirical evidence reveals a consistent and sobering picture of IPO investing. The most well-known stylized fact is IPO underpricing, which refers to the first-day return of roughly 18 to 19 percent for US IPOs since 1980, as reported by Jay Ritter of the University of Florida.

However, the majority of this 'extra' return typically benefits institutional investors with allocations at the offer price, rather than retail investors who buy shares once the market opens. Securing an allocation does not guarantee investment success, as allocations in highly anticipated deals are often limited, while weaker deals are readily available.

This phenomenon, known as the "winner's curse," means that indiscriminately investing in IPOs is likely to yield lower returns than the headline-grabbing first-day gains reported in many studies. Additionally, newly listed companies often struggle to sustain their early momentum. Research indicates that IPOs underperform comparable firms in the initial years after listing, a trend that is particularly pronounced for smaller, unprofitable companies.

This underperformance is largely attributed to market timing, as companies strategically time their share offerings to coincide with peak investor enthusiasm and valuations. This observation aligns with a core investment belief: valuation levels only matter when they reach extreme levels, altering the reaction function of corporate issuers.

Overall, the empirical evidence suggests that patient investors generally benefit from more favorable entry points in the months following a listing, as opposed to the euphoric opening days of the IPO. Of course, this does not imply that investors should entirely avoid IPOs. After all, every successful public company originated as an IPO, and many tomorrow's biggest winners are already in the process of listing.

The key takeaway is one of patience and discipline. Lock-up periods, which expire when insider selling restrictions are lifted, can serve as useful indicators for reassessing the sentiment towards newly listed companies. As more shares become available for trading, the market must absorb the additional supply, which can exert downward pressure on share prices if demand does not keep pace.

While private market investments might seem more attractive when viewed through the lens of the average public market investor, who is structurally late to the party, this does not automatically make them more attractive. In fact, venture capital returns are highly skewed towards the earliest funding rounds, during which access is limited and identifying future outliers with any degree of certainty is extremely difficult.

For most investors, the crucial point is to maintain disciplined investment strategies in both private and public markets. Historically, private markets have provided attractive opportunities, especially for investors working with experienced managers who have access to promising companies at earlier stages of development. However, the label "pre-IPO" does not guarantee superior returns; access, manager selection, and valuation remain critical factors, just as important as they are in public markets.

Ultimately, investors cannot afford to overlook the potential for significant long-term growth in exceptional public companies. The goal should be to participate in the long-term growth of these businesses, rather than prioritizing access to them at the earliest possible stage. Instead of rushing to secure a pre-IPO or IPO allocation at any cost, investors would be better served by exercising patience and building positions once the initial volatility of IPOs has subsided, while still allowing the company's long-term compounding potential to be realized. Yves Bonzon serves as the group chief investment officer at Julius Baer.