Don't Let the Boiling IPO Market Burn You

The U.S. IPO market during the past year has posted a strong performance relative to the S&P 500. In 2011, IPOs have outgained the S&P 500 by nearly 700 basis points with an overall return of 13.2%. This performance is even more impressive when excluding Chinese IPOs--deals that have faced severe investor wrath because of accounting issues and potential fraud--which have contributed an overall negative 4% return to date so far this year.

Although this outperformance might be impressive, we continue to caution investors to look past the hype and focus on company fundamentals, long-term prospects, and the appearance of an economic moat, in order to avoid getting burned. With the amount of bullishness surrounding the current IPO market, we'd like to explore it in further detail.

Looking at the Numbers
Through July 25, 2011, we've seen around 81 IPOs with total capital raised of around $26.5 billion. This is ahead of the pace set last year, with only 74 IPOs up to this point. The $26.5 billion in capital raised reflects even further how hot the market has been through the first half of this year, as 2009 and 2008 turned in $27.3 billion and $26.8 billion worth of capital increases, respectively, for the entire year. From a volume standpoint, this is the fastest pace of deal flow since 2007--a much frothier time on the eve of the economic crisis that roiled the markets, in which there were 138 IPOs by this date. Even though we don't expect the total number of deals to reach those levels, we see continuing strong volume through the rest of the year with a full pipeline of deals. As the market for IPOs has been particularly strong, certain sectors have clearly outperformed others. Surprisingly leading the way is consumer, with an average return percentage of 21%, followed closely by basic materials with a return of 18.8%.

Although technology isn't the top IPO sector, it has still returned an impressive 12.2%. Even though social-networking platforms, such as  LinkedIn , have soared, other tech offerings with weaker fundamentals, such as Boingo Wireless , which is down 39%, have helped drag down the overall sector.

Other interesting data so far in 2011 relates to underwriter and exchange performance. Underwriter performance can be a little confusing, as the underwriter could have done a great job selling the company going public and at the same time allowed it to leave money on the table if the issue soars in secondary trading, which has happened a few times this year.  Jefferies Group  appears to be the early leader, with an average return of 32.5% on its deals, with the most notable being Francescas Holdings , up 66.5% from its offer price.

Where the Deals Are
With respect to exchange performance as measured by volume, roughly 58% of the total deal flow has priced on the New York Stock Exchange, with another 40% making its debut on the Nasdaq, and only a very small percentage pricing on the American Stock Exchange. Although the NYSE may have the majority of the deals, the IPOs on the Nasdaq have outperformed the NYSE by nearly 10.0%, with a 20.4% return average. It seems the smaller, higher-growth, tech-related deals typically priced on the Nasdaq have played a role in the performance disparity.

Regarding the current market temperature, the last two months have demonstrated the highest average return percentage so far this year, with July leading the way at a roughly 27% clip and June a close second at a 22% average return. It's possible this effect is somewhat seasonal, as investors look for more growth or alternative investment opportunities away from the stagnant returns of the blue-chip companies. Although the overall IPO market has been strong, especially recently, not all has been positive. Of the 81 IPOs, 11 have come from China, with the average return percentage of negative 4% sorely underperforming the rest of the market.

The poor performance of many Chinese IPOs can partially be explained by allegations of fraud, material weaknesses around accounting standards, and firms playing in competitive industries. As many investors learned with Renren (RENN), there is a huge difference between Facebook and the "Facebook" of China. Three bright spots from the country include Taomee Holdings , which we called a sleeper pick before its IPO. Taomee has returned about 65% from its initial offer price. The other two with positive returns have been tech-related, including Jiayuan.com  and Qihoo 360 Technology . Going forward, we expect that an IPO will be difficult for Chinese companies that either aren't tech-related or have reported material misrepresentations. We saw this most recently with Xunlei , which couldn't get its deal out of the door and ultimately postponed its offering.

Specific stocks have contributed more than others to drive the strong U.S.-domiciled returns in 2011. LinkedIn, for example, has been the top performer with a roughly 124% return. Along those lines, it seems that any company with the possibility of forming a moat (in this case, a network effect) will be in high demand from investors, even if the company is not currently profitable. We have seen this recently with HomeAway  and Zillow (Z), up 52% and 78%, respectively. Neither company is currently profitable, but we think both have strong growth opportunities and the potential for a moat down the road. With that said, though we value growth, we think it is definitely important for investors to also understand those companies' competitive environments, as both HomeAway and Zillow face intense competition.

Adam Brand contributed to this analysis.

This report is made available compliments of Morningstar IPO Research Services. For more information on Morningstar IPO Research, please click here for more information.