Investing in stock market newcomers: a sensible strategy?

In recent months, several newcomers to the stock market (IPOs) have made a notable entrance.

Aerospace company Firefly increased threefold on its first day, while the crypto platform Bullish closed at +84% on the boards. Stablecoin issuer Circle reported a 170% increase and software company Figma soared by 250% at its debut. The first Belgian newcomer in years, EnergyVision, was also up a fifth (source : Bloomberg Finance LP, July-August). It's no surprise, then, that many investors are asking themselves whether it is worthwhile to invest in IPOs.

1. What exactly is an IPO?

An IPO (Initial Public Offering) is a company that is offering its shares for public sale on the stock exchange for the first time. This initial listing gives the company access to capital from a broad base of investors. An IPO therefore transforms a private company into a listed company.

By issuing new shares, a company can raise capital for such things as an international expansion, investments or debt repayment. An IPO also often represents a partial exit for current shareholders. Early investors, such as venture capitalists or family owners, can sell all or part of their shares and redeem their investment through the IPO.

In addition to capital and exit opportunities, a stock market listing offers additional advantages. Firstly, it increases brand awareness. A public company often benefits from increased visibility and status. This in turn can increase trust among customers, partners and lenders. In addition, a stock market listing enhances liquidity for shareholders: their shares can be traded freely, providing greater flexibility compared to illiquid private investments.

2. Why do investors find IPOs attractive?

An IPO provides investors with the opportunity to become shareholders in a company that was not previously easily accessible. The idea of 'getting in early' on a potential future success story resonates with many investors. IPOs also open the door to new sectors or innovative business models that were not yet represented on the stock exchange.

IPOs are often accompanied by significant media attention and high expectations. If these expectations are exceeded, the stock price can soar rapidly on the first trading day. Those who subscribed to the introduction price before or at the time of introduction can then immediately enjoy a nice gain in principle.

Aside from rational arguments, other factors may come into play with IPOs. Investors who personally like a brand or company want to 'own a piece of it' as soon as it goes public. A good example is the hype surrounding Facebook’s IPO in 2012, Ferrari in 2015 or the handful of football clubs that are now listed on the stock exchange. This kind of commitment can be rewarding, but be careful not to get involved solely out of enthusiasm. It is essential to also consider the fundamental aspect of the issue.

IPOs are often launched when the stock market is doing well and investors are willing to take more risk. This is far less common in times of crisis. For investors, it means a buoyant market results in more IPOs, but not necessarily better opportunities. It is important to consider the reason for the IPO. Are new shares being issued to invest in growth or acquisitions? If so, this is a positive sign. But if the IPO is primarily to be used to pay off debts or sell existing shares held by major shareholders, this is often less advantageous. In this case, you need to ask yourself: if the largest shareholder is pulling out, why should I invest?

3. How do IPOs perform on the first day?

Many IPOs rise on the first day compared to their issue price. Between 1980 and 2024, IPOs on the American stock market increased by an average of 18.9% at their debut (source). This can partly be explained by the fact that the offering parties (the company and accompanying banks) often set the price somewhat conservatively to generate sufficient demand and ensure a smooth debut. Sometimes, this demand is artificially stimulated by bringing only a limited or very limited number of shares to the market. The result is high demand combined with low supply, which can push the price up even further.

In years when investors are optimistic, that first-day gain can be much higher. This has been shown by research conducted by Professor Jay Ritter (nicknamed Mr IPO), who has been studying IPOs for decades. During the peak years of the dotcom bubble, the average price surge on the first day was exceptionally high: 72.1% in 1999 and 56.3% in 2000. The years 2020 (41.6%), 2021 (32.1%) and 2022 (48.9%) were also remarkable thanks to a number of highly hyped IPOs (DoorDash, Airbnb, Snowflake) and SPAC deals such as Nikola and Lucid Motors. A SPAC, or Special Purpose Acquisition Company, is a blank cheque company that raises funds in order to take an existing company public later on.

4. What about the long-term returns?

The key question is whether IPOs will sustain their strong performance after the initial euphoria. Once again, Ritter's research offers a sobering perspective. Investors who purchase an IPO share on the first trading day and hold onto it for a longer period tend to experience lower returns on average. Many IPOs achieve a lower return over three to five years than comparable existing shares or indices.

Ironically, IPOs in gloomy stock-market years sometimes turn out to be better long-term winners than those in years of (excessive) stock-market optimism. Ritter points out that years when investors were lukewarm about IPOs – such as 1980 or 2008 – still produced several standout successes, such as Apple in 1980 and Visa in 2008. During those lean years, only the strongest companies entered the market (others did not have the courage), which ultimately contributed to their later success.

Conversely, during periods of market overheating, we saw a surge in IPOs of questionable quality. In 1995-2000, for instance, nearly 1,400 tech companies entered the US stock exchange – many without profit. Most of them no longer exist. During the pandemic boom of 2020-2021, there was also a peak in loss-making tech IPOs, many of which subsequently disappeared over time.

5. Are certain sectors doing better?

On average, some sectors perform better or worse in countries with IPOs. Technology and biotech launches are often hyped, with substantial gains on the first day, but they also come with the risk of significant disappointment later on if expectations are not met. Companies in traditional sectors (industry, financial services) typically have less spectacular debuts, but often show a more stable performance afterwards. The size and maturity of the company also play a role. Large established companies that go public (e.g. a spin-off from a conglomerate) often already have a track record of profitability and can deliver more reliable returns than very young start-ups that still need to demonstrate their potential.

6. Can anyone subscribe to an IPO?

In principle, any investor can participate in an IPO, but there are practical considerations. As a client of a bank or trading platform, you can subscribe to an IPO provided that your bank is involved in the offering. It is almost never possible to participate in foreign IPOs. And with a Belgian IPO, the possibility to subscribe is not always guaranteed, even if the broker offers this service. Some companies choose to reserve their IPO exclusively for institutional investors, thereby excluding retail investors.

But even if you did not subscribe during the subscription period, you can still purchase shares once the company is officially listed on the stock exchange. You then place a stock exchange order. However, caution is warranted, as the opening price may be considerably higher than the initial offering price if there is strong interest.

7. How can you prepare as an investor?

Investing in an IPO may require more research than when investing in established shares. After all, you are dealing with a company without a stock market history. A few steps that ensure you are well prepared:

• Read the prospectus carefully. This legal document includes all the details about the company, its financial results, strategy and most importantly, risk factors. Although it may not be the easiest document to read, it is worth at least reading through the summary and sections on financial results and risks. This information will tell you whether or not the company is profitable, what it intends to do with the funds raised and so on.
• Analyse the industry and competition. Take a close look at the sector in which the company operates and evaluate its prospects. If there are publicly listed peers, examine their valuations in order to put the pricing of the IPO into perspective.
• Prepare a post-IPO strategy. Are you planning to hold onto the share in the long term as a strategic investment or are you looking for a quick profit by selling when the price rises? Long-term investors will be less concerned about daily fluctuations and more inclined to buy in if they believe in the narrative, while 'flippers' have to remain vigilant to earn a profit when it peaks. Set a stop-loss level in advance that protects you against excessive losses should the IPO disappoint.
• Treat the IPO as a risky investment. Invest only a small percentage of your portfolio in it, so that a setback does not cause too much damage. Diversification remains your best defense. No matter how enthusiastic you may be, the outcome is always uncertain. Not every IPO will be the next Apple or Alphabet. Preparation also involves being mentally ready for various scenarios: from a price that doubles to one that gets cut in half in short order.
• Don't be tempted just because 'everyone's talking about it'. Or because you’re afraid of missing out on the next big thing. Invest based on facts and analysis, not because an IPO is hot and trending.

Before investing, be sure to read up on the main characteristics and risks of financial instruments.

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