IPOs are good for companies. They can be even better for investors.

by First Trust | Nov 12, 2018
Everyone loves a good initial public offering. The buzz over hot new listings and the stories of runaway successes have been fuelling investors’ optimism for generations. Yet, even though everyone knows what IPOs are, people rarely invest in them. Sometimes, if a company’s product has a large consumer following, like in the cases of Facebook or Tesla, a larger crowd gets in on the action. But more commonly, it’s mostly professional investors who are in the know. And even then, a traditional mutual-fund investment portfolio will typically hold only a handful of newly-listed or spun-off companies.
Everyone loves a good initial public offering. The buzz over hot new listings and the stories of runaway successes have been fuelling investors’ optimism for generations.

Yet, even though everyone knows what IPOs are, people rarely invest in them. Sometimes, if a company’s product has a large consumer following, like in the cases of Facebook or Tesla, a larger crowd gets in on the action. But more commonly, it’s mostly professional investors who are in the know. And even then, a traditional mutual-fund investment portfolio will typically hold only a handful of newly-listed or spun-off companies.

Often, regardless of a company’s long-term potential for success, the primary interest of many investors seems to resolve around the short-term surges or drops in price of IPOs. But we feel the biggest opportunities can come from avoiding the first few days of trading and hold for the medium term.

This knowledge gap presents a unique investment opportunity. Investors have long known that IPOs and corporate spin-offs have special trading properties. It’s no coincidence, for example, that these stocks tend to soar on the first day of trading: public offerings tend to be under-priced to entice investors and compensate for the risk of betting on a new company.

But new listings can generate excess gains over the short and mid-term as well. People are often surprised to learn that, at any point in the last 15 years, at least 60% of the Russell 2000 market cap was generated by companies that were listed or spun-off during the previous four years.

And the proof, as they say, is in the pudding. The IPOX®-100 US index, structured specifically to capture the unique trading properties of IPOs and spin-offs – discussed later in this article – was launched back in 2004. Over the past 14 years, it’s generated over 6% of annualised outperformance over the S&P 500. This amounts to considerable gains, as illustrated by the chart below.

IPOs Can Be Good For Companies


Source: FactSet, Bloomberg. Data shown is from 06/8/04-28/09/2018. Past performance is no guarantee of future results. This information is for illustrative purposes only and not indicative of any actual investment. The illustration excludes the effects of taxes, brokerage commissions, and other expenses incurred when investing. An index cannot be purchased directly by investors. Please see endnotes for a definition of the indexes and investment terms.

IPOs and spinoffs are a surprisingly attractive theme


Investing specifically in IPOs and spin-offs is an example of thematic investing. Under this philosophy, investors are indifferent to whether a company is a technology stock or a farming stock, provided the firm is engaged with or directly affected by the desired theme.

We believe IPOs and spin-offs are a highly appealing theme thanks to two particular features:

IPOs are good for companies. They can be even better for investors.

1. Newly-listed companies commonly outperform over the short term. Because there’s no history of public reporting, such companies are perceived as riskier, and market expectations adjust for a higher payoff. The greatest returns are also where the stakes are highest, with outsized returns delivered by the larger IPOs:

IPO Performance by Market Cap
by months following listing

IPOs Can Be Good For Companies 2

Source: IPOX Schuster, LLC. Unadjusted returns of an equally-weighted sample of U.S. Listings (1985-2017). Month 0 is the initial return. Past performance is no guarantee of future results.

2. Post-listing performance is commonly – and we believe mistakenly – considered volatile. In the longer term, company performance tends to cluster: some companies emerge as clear winners, others fail miserably, and the majority display a generally lacklustre performance. As illustrated above, the median performer delivers little-to-no gains over a four-year horizon.

This shows why stock-picking IPOs is so tricky: if you get lucky picking just the right IPOs, returns could be massive. But in all probability, and with limited information, you’re likely to pick a dud.

IPOs Can Be Good For Companies 3

Investors can potentially capture the gains from the two features above through the First Trust US IPO Index UCITS ETF (The “Fund”). This Fund tracks the IPOX®-100 US IPO Index, whose construction process is outlined in the table below:

A new way to diversify

IPOs Can Be Good For Companies 4


In recent years tech listings have generated most of the buzz. But, as the chart shows, the Fund is particularly well-diversified on a sector basis.

The sector allocation also reflects the wider economic climate, since the only companies able to raise cash are those whose business model the market finds sufficiently attractive. For example, back in 2008 – and ahead of the financial crisis – the index rebalanced to reflect a rotation into safer plays like consumer staples.

The Fund also acts as a quality sift. True, there were fewer-than-average IPOs in 2008 and 2009 (though far from zero). But it’s only companies with a highly viable business that can raise funds during an economic downturn.

The listing of a company doesn’t just reflect a competitive edge – it also helps create it. By getting cash in the door, newly listed companies can expand their marketing and sales teams and go after new markets. They’re also able to invest in R&D.

With only 4% of the companies held by the Fund featuring as constituents in the S&P500, the Fund offers material diversification* opportunities. In an upcoming webinar, we’ll be discussing some of the key holdings.

Join Us

Thematic investing enables the client to gain exposure – with a single transaction - to a group of companies tied together by a theme, rather than their country of domicile, sector classification or exchange listing. IPOs and spin-offs represent a highly attractive theme, which is also backed by a wealth of data.

First Trust is one of the largest players in thematic ETFs, as well as the 6th largest ETF sponsor in the US. Since the firm’s inception, First Trust has successfully launched a series of thematic products, in areas including IPOs, the internet, cyber security and blockchain.

Join our upcoming webinar, presented by First Trust senior product specialist Gregg Guerin, to hear insights on how IPOs can potentially deliver gains – not just to companies– but to you.

Footnotes

*Diversification does not guarantee a profit or prevent against a loss. Mention of specific securities should not be considered a recommendation or assumed to be profitable.
Index Descriptions
The Russell 3000® Index is comprised of the 3000 largest and most liquid stocks based and traded in the U.S.
The S&P 500 Index is an unmanaged index of 500 stocks used to measure large-cap U.S. stock market performance.
The S&P MidCap 400 Index is an unmanaged index of 400 stocks used to measure mid cap U.S. stock market performance.
The S&P SmallCap 600 Index is an unmanaged index of 600 stocks used to measure small cap U.S. stock market performance.
A patent with respect to the IPOX® index methodology has been issued (U.S. Pat. No. 7,698,197). IPOX® is a registered
international trademark of IPOX® Schuster LLC (www.ipoxschuster.com).

Risks
The Fund's shares may change in value and may go down as well as up. You could lose money by investing in the Fund. You may not get back all of the money you invest.
The Fund is subject to market risk, which means that shares of the fund may fall in value due to market fluctuations caused by such factors as economic, political, regulatory or market developments, changes in interest rates and perceived trends in securities prices.
There may be tracking difference between the Fund and the underlying index due to the impact of annual Fund management fees. Therefore the Fund’s return may not match the return of the IPOX®-100 U.S. Index.
The Fund’s holdings may be issued by companies concentrated in a particular industry or country.
The Fund may invest in small capitalisation and mid capitalisation companies. Such companies may experience greater price volatility than larger, more established companies.
As the Fund’s investments may be denominated in currencies other than the Fund’s currency, an investment in this Fund may expose you to currency risk.
This Fund’s Net Asset Value (NAV) is likely to have high volatility due to the portfolio composition and/or the index replication technique. As such, potential investors should be aware that the Fund’s shares will change in value, and may do so in a volatile fashion; potential investors could lose money by investing in the Fund.
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