Individual Investors: Handle IPOs With Care

Stay tuned this week for Morningstar.com's coverage of Twitter's IPO.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm here today with Morningstar equity analyst Jim Krapfel to looks at the health of the IPO market and also how investors should think about initial public offerings, like Twitter.

Jim, thanks for joining me.

Jim Krapfel: Thanks for having me, Jeremy.

Glaser: All the attention on Twitter's IPO has really brought the IPO market into many investors' spotlights recently. Can you tell us a little bit about the health of the market right now, and how that compares to what it's looked like over the last few years?

Krapfel: I'd say the IPO market right now is very healthy. We're seeing lot of offerings this year, much more than last year. So far this year, we've seen 170 offerings and that compares to 131 for all of 2012, which had increased over prior years, too. Year-to-date, offerings are on pace with what we'd seen from 2004 to 2007 on average, which were fairly high levels, but certainly not at the levels we saw in the late '90s, when all these tech companies were going public.

Glaser: What's driving these companies coming to market? Is it private equity exits? Is it that folks just need to raise capital? What's driving this?

Krapfel: I think really it's that stock market valuations have been very strong. The market overall is up anywhere from 30% to 35%, and companies like to go public when valuations are strong. So they're seeing their peers in the same industry being priced at very high valuations, and then you're seeing other companies go public at pretty strong levels, too. So, that means they can raise more proceeds than they could in a weaker market. So, really it's been driven by the strong equity market, which is also being boosted by low-interest-rate environment.

Certainly, we're seeing some private-equity-backed companies go public at increasing rates. Private-equity investors tend to be fairly smart. They like to time their exits very carefully. When the stock market falls 10%-15%, they're quick to pull any offerings, and then come back to the market when valuations are stronger [like this year]. …

Glaser: There have been some recent legislative changes, things like the Jobs Act, to try to make it easier to come to market. Do you think that's had a big impact, or is it mostly those valuation factors you talked about?

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Krapfel: It's difficult to quantify the exact impact the Jobs Act has had on the IPO market, but I think net-net, it's been a slight positive. Some of the positive virtues, or aspects, of the Jobs Act are that companies don't have to provide as many financials, years of financials, that they used to. They don't need auditor attestation to their financial results. They can file privately with the SEC until only three weeks before their roadshow begins. So that means that their competitors [don't] see their S-1 or their registration statement [until] later in the process, so it's less revealing of key data that would help their competitors. So, that's all positive for the company.

The only partial offset I think that the Jobs Act has to those positive aspects is that a company is only forced to provide public documents once the public shareholder count reaches 2,000, instead of 500 before. So, these startup companies can acquire new investors to get up to 2,000 before they have to release their financial documents. So, I think that is preventing some would-be companies from going public, but I think net-net the Jobs Act is propelling more companies to go forward.

Glaser: Obviously a lot of things in that Act made it easier for companies to go public, but that doesn't say a lot about [whether] investors should be jumping into them. What have the performance numbers looked like for offerings this year? What has the investor experience been?

Krapfel: For all of 2013, the median total IPO return has been 19%, and the average return is 37%, so that's pretty strong. When you look at it from a first-day close price, which I think is more realistic for retail investors trying to get into an IPO, then the figures fall to 8% and 18%, respectively.

Another way to track IPO performance is looking at First Trust's IPO Index Fund, ticker FPX. It's a market-cap-weighted index of recently public companies that are trading within 1,000 days of their IPOs, and that index is up 39%, which is outperforming the Russell 2000, which is up 33%, and the S&P 500, which is up 26% year-to-date. So clearly, the IPO market has been very strong.

Glaser: What does this mean for most individual investors? Should they be considering IPOs? Should they be trying to get allocations, if they can, in certain offerings, or is there just too much uncertainty for them to really be in this market?

Krapfel: In a world where individual investors could get allocations at the IPO price, I think it's a very wise move. Most companies do pop in the first day. However, the reality is that very few individual investors can get any meaningful allocation to IPOs. Especially highly sought-after IPOs, fast-growing companies, it's very difficult to get more than, say, 100 shares, even if you qualify, which means you have more than, say, $250,000 in your account or trade a lot within your account.

The reality is, people who want to get involved in IPOs have to buy them after they go public, and usually you [miss] that pop. In today's environment, IPO markets are very strong, possibly considered frothy. So, you're really paying up for that excitement in that possible growth. So, I think investors need to be very cautious with regards to IPO investing.

Glaser: So investors still really need to be focused on the fundamentals.

Krapfel: Clearly. And investing in companies that they know versus some random biotech that they don't really know, [just because] they've seen biotech offerings go up significantly this year.

Glaser: Jim, I really appreciate your thoughts on the IPO market today.

Krapfel: Sure. Glad to be here.

Glaser: For Morningstar, I'm Jeremy Glaser.

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