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Initial Public Offerings

Gary Karz, CFA (email)
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Principal, Proficient Investment Management, LLC

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Background and Research

     Initial Public Offerings (IPOs) can generate a great deal of interest and media attention especially when they experience large increases in value during initial trading. A number of free services appeared on the web in the 90's providing information about IPOs, but many did not survive. Still information on IPOs is much easier to access these days.

     Getting the opportunity to buy shares of IPOs on the offering is a challenge for most investors. But investors should beware that a great deal of evidence shows that in the past, IPOs in aggregate have underperformed the market and comparable companies. Research showing that IPOs are poor long term investments has existed for quite a while. A frequently referenced study by Tim Loughran and Jay R. Ritter discussed both IPOs and secondary offerings. The article appeared in the March 1995 issue of the Journal of Finance. In The New Issues Puzzle the authors studied IPOs and seasoned equity offerings (SEO) from 1970 to 1990 and found that both underperformed. REITS and ADRs were not included in the study. The authors concluded that "Our evidence is consistent with a market in which companies announce stock issues when their stock is grossly overvalued, the market does not revalue the stock appropriately, and the stock is still substantially overvalued when the issue occurs." More recent results (which continue to show that IPOs underperform) are included in Ritter's Returns on IPOs during the five years after issuing, for IPOs from 1970-2007.

     Another study showed that analysts overestimate IPO earnings. See "Sell-side analysts overprice stocks" by Marlene Givant Star in Pensions and Investments 10/14/96 and "Wall Street Analysts Too Upbeat on IPO Earnings, Study Finds" from Reuters in The Los Angeles Times 10/23/96. The articles referred to research by Richard Sloan, Patricia Dechow, and Amy Sweeney. They found that long-run earnings forecasts by sell-side equity analysts were systematically overly optimistic, particularly those employed by the lead underwriter. Despite Chinese Walls between their underwriting and research departments intended to prevent conflicts of interests, the researchers said: "the study's results are consistent with investment banks using their sell-side analysts to help promote their underwriting clients."

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