Investing in IPOs Can Be Tempting, Given the Potential Gains. But the Potential Losses Can Be Immense Too. Here’s How NOT to Lose Your Shirt on New Stocks.
Most people want to invest in IPOs. Trouble is: if you do it wrong, you could lose your shirt in an instant. These early-stage stocks need to be handled with a little extra consideration because they are so new to the public markets and the stocks don’t have a lot of trading history.
Two of the biggest considerations are: (1) When to buy an IPO that you like given that the stock’s post-IPO trajectory is usually down, and (2), what to do about the lockup expiration date. Do you buy before, on, or after?
Let’s tackle the first consideration first.
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When to Invest in IPOs
After the IPO (initial public offering) event there is often a period I refer to as the post-IPO blues. This is when the excitement of the IPO roadshow and big event have passed, and a stock settles down into real life as a public company. In general, this happens at some point in the first four months of trading, and after the initial IPO surge (which usually happens on day one). The stock then trends down, often landing well below its IPO price.
This pattern (which happens often, but not always) scares a lot of would-be investors away because, why buy a hot new stock if it’s going down every day? Where’s all the investor demand?
This pattern happens over and over because it takes several quarters for everyone to understand the ebbs and flows of revenue and earnings, get comfortable with the company’s business model and cozy up to management’s communication style. There is a relationship to build between a stock and its public investors. And that just takes time.
How long? Usually, at least six months (180 days), but often more. And only afterward will the newly public stock begin to settle into a trading pattern that we can begin to understand.
What To Do About Lockup Expiration
Not coincidentally, another major event happens around that six-month/180-day milestone. It’s called lockup expiration. When a company goes public, insiders (founders, employees, management, VC firms, etc.) are prohibited from selling shares. The restriction is usually 180 days, and is intended to protect IPO investors from intense selling pressure right after they’ve jumped in.
The lockup expiration day is when these insiders are free to sell. And they often do, which, rationally, seems concerning to many investors. Why buy a stock if people on the inside with a lot more knowledge are selling?
Don’t worry about it. Insider selling happens for a lot of reasons. One of the main ones is that insiders, just like the rest of us, want to diversify their holdings. The IPO is a liquidity event that helps them realize the paper profits they’ve built up over the years. It’s totally understandable that a founder, early investor, or loyal employee would want to book a profit and free up some cash to do whatever the heck they want with it.
In other words, insider selling – including around lockup expiration – is not always an indication that these people think the company is going to hell. They usually just want to do what any one of us would – cash out some of their position and not have their financial future so intensely reliant on what happens to one company.
But what about buying in the months before these insiders are going to start selling some (usually not all) of their shares? Is that a dumb move?
No, it’s not.
Recent data from JP Morgan shows that the fear of lockup expiration is far worse than the actual event. Why? Because it’s a known event, so investors can strategize around it.
JP Morgan analyzed 21 IPOs dating back to March 2018 and found that the stocks were down an average of 10% in the 30 days before lockup expiration (i.e. in the period of 150 to 180 days after IPO) but then were up in the one-, five- and 30-day periods after lockup, with average gains of 0.4%, 2.2% and 8.3%, respectively.
Notably, 16 of the 21 stocks (76%) were down in the month before lockup, while only five (24%) were down in the five-day period after, and only five (24%) were down in the 30-day period after.
As always there are caveats to pure data analysis. Still, this data offers compelling evidence that when looking specifically at lockup expiration, investors shouldn’t be overly concerned about a flood of shares hitting the market and crushing the stock.
In fact, the opposite is seen to be more accurate – shares of IPOs tend to rise at, and soon after, the lockup expiration date. This implies that buying in the 30-day period ahead of the event (150 to 180 days after IPO) could be a wise move.
Where To Find The Best IPOs
Stepping back, my advice is to think about buying newly public stocks as a process rather than a point in time. Average into the stock in several purchases (three to four, at least) over time (30 to 60 days, at least) to spread out your cost basis. Specifically, look to make at least one purchase when the “post-IPO blues” have settled in, and another in the 30-day period leading up to lockup expiration.
This isn’t going to work perfectly for every single IPO out there as there are always outliers that shoot straight up, and those that fall apart and never recover. But following these general guidelines and adjusting to the specific situation as an IPO matures should lead to better IPO investing success.
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Tyler Laundon is chief analyst of Cabot Small-Cap Confidential. The circulation of Small-Cap Confidential is strictly limited because the undiscovered stocks with sky-high-potential that Tyler recommends are often low-priced and thinly traded. Don’t share these recommendations!Learn More