IPOs in the last two years have not been very successful by historical standards. However, new IPOs could be different. picture alliance / Zoonar | Kyrylo Shevtsov
After the flood of new listed companies between 2020 and 2021, the number of new IPOs recently fell.
Goldman Sachs says new IPOs are coming, but not all will outperform the market.
Chief Information Officer David Kostin shared two reasons why some IPOs have been more successful and how you can spot outperforming stocks on day one.
Disclaimer: Stocks and other investments generally involve risk. A total loss of the capital invested cannot be ruled out. The articles, data and forecasts published are not a solicitation to buy or sell securities or rights. They also do not replace professional advice.
The IPO market was in full swing after the outbreak of the pandemic: money flooded the market, investor sentiment was good and new instruments kept the floodgates wide open for the new listed companies.
More than 400 IPOs and 810 SPACs came to market between 2020 and 2021, according to Goldman Sachs.
But as interest rates rose, money became scarce. The mood plummeted and with it many failed Spacs. In the last 21 months, starting 2022, there were only 32 IPOs.
However, a comeback in IPOs could be coming soon. David Kostin, Chief Investment Officer at Goldman Sachs, recently pointed out a positive development in a note to clients: The macroeconomic conditions that favor successful IPOs are gradually returning. After strong IPOs from Arm and Instacart last week, more IPOs could be on the way.
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However, more IPOs do not necessarily mean they will be successful. And smart investors need to distinguish new, quality stocks from overhyped entrants that only rise on day one.
How to recognize an IPO that will hit on the first day of trading
Many investors miss the heyday of IPOs in 2020 and 2021. In reality, the companies that went public at that time did not see the highest price increases.
“The 2020-2021 wave of IPOs had a miserable performance by historical standards,” writes Kostin. “The median 2020-2021 IPOs underperformed the Russell 3000 by 48 percentage points over the first twelve months. The median of all IPOs since 1995, however, is only minus 20 percent.
Of the 2020-2021 IPOs, only 18 percent have outperformed the Russell 3000. The median figure for all IPOs after 1995 was 35 percent.
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It is not the case that the companies that went public in these years were necessarily bad investments, contrasts Kostin. At the beginning of the 2020-2021 wave, falling interest rates seduced private companies and brought them to the public markets. However, interest rates eventually rose and these companies found themselves in a bind. They watched multiples shrink, valuations fall, and their stocks fall as a result.
A strong IPO is not a strong indication of a good investment
Most stocks that have gone public in the past two years have soared on the first day, with a negative performance thereafter.
Stocks that went public between 2020 and 2021 typically rose 15 percent on the first day of trading. The stocks from the period between 1995 and 2019, on the other hand, only rose by ten percent on their debut day, said Kostin.
Typically, stocks that rise sharply on the first day also see their prices rise a few months later.
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“IPOs that rise more than 50 percent on their first day of trading typically experience an additional five percent increase in value over the following three months. On the other hand, stocks that do not reach the 50 percent mark on their stock market debut remain at just one percent,” writes CIO Kostin. “A falling stock on debut day typically falls another four percent over the following three months.”
So how do you recognize stocks that are going to make a move on debut day? Pay attention to the expected price range of the stock.
“Since 1995, stocks trading above the range have gained 38 percent on the first day of trading,” Kostin wrote. This trend has only increased over time. Since 2020, companies whose share prices are above the expected price range have increased by 43 percent on the first day of trading.
However, the Goldman Sachs CIO contrasts that the performance immediately after the IPO is not a strong signal of a long-term increase.
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Two key features that make an IPO a good investment
The price increase on the first day certainly feels good, but investors are usually more pleased when their new shares perform positively over the next few months. According to Goldman Sachs, this can be seen in two key characteristics: revenue growth and profitability. This is shown by the analysis of 5,000 IPOs over the last 25 years.
“Most companies underperform on the stock market after their stock market debut. However, outperformers have two characteristics: a sales growth of more than 40 percent in the second and then again in the third year after the IPO on the one hand and a positive net profit in the eighth quarterly report on the other hand.
According to Kostin’s note, two-thirds of new stocks with these two characteristics outperformed the Russell 3000 in their first two years, outperforming by 22 percentage points.
Sales growth and profitability are the key to success after an IPO. Goldman Sachs
The loose monetary policy of 2020 and 2021 triggered a flood of IPOs from companies looking to take advantage of the opportunity, Kostin said. However, these companies were unprofitable and had low sales growth. With such disadvantages, it is no wonder that the shares of these companies plummeted after their IPO.
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Kostin also pointed out that profitability is a particularly important factor.
“We expect profitability to be particularly important in upcoming IPOs. With capital markets closed for nearly two years, unprofitable companies have been forced to finance their operations through expenses,” Kostin wrote. “This experience has led investors to favor stocks with high current profitability.”
Konstin says investors should approach highly valued IPOs with caution. No company that went public in 2020 or 2021 with a price-to-sales ratio of more than 15 times its next 12 months’ sales was able to outperform the Russell 3000 in the first year after its IPO.