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Rethinking IPOs
First Trust Advisors
By Ryan Issakainen
January 30, 2013


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In the wake of the Facebook IPO last spring, and the ensuing public relations debacle, many investors have become more wary of newly minted stocks. Even before this event, the public perception regarding IPOs was heavily influenced by the IPOs of the late 1990s that helped fuel the dot-com bubble. For many, the primary motivation for investing in IPOs has been the potential to receive a short-term surge in price, irrespective of a stock’s longer term potential for success or failure.

However, there is a compelling case to be made for investing in recent IPOs and spin-offs beyond their first week of trading. In this newsletter, we will consider the investment case for this group of stocks, we’ll take a closer look at a disciplined strategy for investing in recent IPOs and spin-offs, and we’ll consider how this strategy might fit within a diversified investment portfolio.

 

 

Why invest in recent IPOs and spin-offs?

Foundational to the case for investing in recent IPOs and spin-offs is the recognition that there are unique dynamics that impact these stocks, which are not shared by more seasoned stocks, and which tend to fade away over time. For example, in the early stages after a stock’s initial public offering, “lock up” and short-selling constraints may bias returns. Additionally, there may be a substantial amount of information asymmetry among market participants; initially, investors are heavily reliant upon data provided in the stock’s prospectus, while many analysts are subject to a “quiet” period before issuing research reports or forecasts.

Following the expiration of the quiet period, as analysts begin to initiate coverage, there is a relatively wide dispersion of subsequent returns. Notably, following the initial week of trading, the majority of new IPOs and spinoffs in the US have tended to produce negative returns during the subsequent 12, 24, 36, and 48 month periods (see “% negative” in Table 1 below). However, the best performing stocks from this group have more than compensated for the losers, producing attractive average returns for the group as a whole during these same time periods (see “average returns” in Table 1 below). So, while the odds may be stacked against investors attempting to select a few winners from this universe, broader exposure to recent IPOs may be more desirable.

 

Table1

Aftermarket performance of IPOs/spin-offs (%) from 1996-2011 (excluding initial returns)1

 

Month 1

Month 3

Month 12

Month 24

Month 36

Month 48

(worst)

-75.35

-99.20

-99.93

-99.99

-100.00

-100.00

(25th percentile)

-7.64

-15.29

-44.00

-66.36

-73.38

-76.50

(Median)

-1.47

2.00

-6.08

-26.01

-31.93

-33.69

(75th percentile)

13.92

23.30

39.11

36.37

40.86

44.98

(best)

7757.14

6864.29

7625.00

13858.51

12378.50

3840.51

Average

9.91

13.53

15.09

12.53

18.63

20.71

(% negative)

44.20

45.95

54.07

62.33

62.69

62.85

 

1Source: IPOX Schuster. Includes equally-weighted results from all US IPOs from 1996-2011, excluding returns from the first day of trading after IPO or spin- off. Past performance is no guarantee of future results. This table 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.

 

One factor that has supported the above average performance of IPOs and spin-offs has been the tendency for successful companies to be targeted by larger companies in M&A deals. According to IPOX Schuster, since the launch of the IPOX®-100 U.S. Index in 2004, 12.2% of index constituents have been targeted in M&A deals, often at significant premiums. 

Another important consideration underpinning the rationale for including recent IPOs and spin-offs in an investment portfolio is the fact that, while these stocks constitute a significant portion of the capital markets (in the US, IPOs and spin-offs have added an average of $150 billion per year to the market capitalization of the US stock market over the past decade2), there is a substantial time lag before they are added to most broad equity indexes. As a result, recent IPOs and spin-offs are generally underrepresented in index-based exchange traded funds (ETFs) and mutual funds and may benefit from broader ownership when they are subsequently added to the index.

 

You should consider the fund’s investment objectives, risks, and charges and expenses carefully before investing. Contact First Trust Portfolios L.P. at

1-800-621-1675 or visit www.ftportfolios.com to obtain a prospectus or summary prospectus which contains this and other information about the fund. The prospectus or summary prospectus should be read carefully before investing.

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). First Trust Advisors L.P. is the adviser to the fund. First Trust Advisors L.P. is an affiliate of First Trust Portfolios L.P., the fund’s distributor.

Not FDIC Insured • Not Bank Guaranteed • May Lose Value         

                                                                                                                                   ETFNEWSL0213

 

 

(c) First Trust Advisors

www.ftportfolios.com

 


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