The Negative Abnormal Performance of IPO Stocks

On the surface, market data shows that stock prices for some groups of IPO companies tend to underperform their relevant, risk-adjusted benchmarks by a significant margin over the first several years of trading. Because abnormal performance, computed by subtracting the benchmark return from the IPO raw return, seems to contradict the efficient market hypothesis for some groups of IPOs, researchers want to explain the contradiction. After all, if IPO stock prices underperform, we would expect the market to adjust prices accordingly for future IPOs. However, IPO underperformance for some groups is consistent through history and across different stock markets around the world.¹ In the case of IPO stocks, researchers have found that there are several key factors that explain this negative abnormal performance and why it persists. A few of the many explanations include the following:

1. Investors change their behavior in response to super-hot IPO markets and are approaching IPO investments differently than other investments.
2. Companies that have a certain profile—including small, non-venture-backed firms—contribute substantially to the overall negative abnormal performance of IPO stocks.
3. Firms that engage in certain behaviors, such as acquisitions, soon after their IPO tend to experience negative stock price performance.
4. The overall performance of the stock market, the performance of a company’s industry, and the competitive attributes of a company’s industry all contribute to IPO stock price underperformance.

If company leaders take the time to understand these explanations, they may be able to improve company stock price performance. Each of these explanations has been the subject of numerous articles and research studies. Although far from comprehensive, this article attempts to summarize and explain the research that is relevant to company leaders who are considering an IPO.

1. When Investors Behave Differently than Expected

In the search to explain the underperformance of IPO stock prices, one of the factors researchers have identified is the propensity for investors to behave differently under certain market conditions. In addition, investors that follow a less traditional investment philosophy may also be a leading cause of IPO stock price underperformance. Understanding the market conditions and investment philosophies that lead to long-term IPO stock price underperformance will not only help investors avoid making poor decisions, it will also help IPO companies understand how investors will approach their stock.

When investor optimism is high, IPO companies receive higher valuations. This entices more companies to go public, increasing the number of IPOs. High valuations and high IPO volume create a “hot market.” These hot markets are normally considered the right time for companies to go public. However, sometimes these hot markets start to overheat, and companies can achieve unrealistically high valuations. Once the hot market is passed, and investors begin to think more rationally and less optimistically, the market will adjust downward. Researchers have noted this exact pattern, showing that hot market IPOs tend to perform particularly poorly in the long run compared to IPOs in normal or cold markets.²

For example, in 2014 investors were getting hungry for restaurant stocks. Several companies went public including chains such as El Pollo Loco, Zoe’s Kitchen, and Shake Shack. The Habit Restaurants, another fast-casual burger chain, took advantage of this “hot market” for restaurant stocks and went public. Despite dramatic first day returns of over 200%, The Habit’s stock prices fell consistently over the next several years. This scenario highlights the propensity of investors to behave less rationally when investor optimism is at its peak in market cycles. In fact, one study showed that IPO stocks with greater than 60% returns on the first day of trading actually had performed worse over the first year than stocks with less than or equal to 0% returns on the first day of trading.^{3 4}

Another important investor behavior to consider is flipping, which is when early investors quickly sell their shares to capture the initial underpricing typical of IPOs. In most instances, flipping is disincentivized in the IPO market by policies and regulations. Flipping is usually considered detrimental to the market because of the perception that investors who flip their IPO stocks are just trying to make a quick profit. The research shows that contrary to this belief, flipping can be seen as a rational behavior. One study showed that the amount of flipping (defined as seller-initiated trades of 10,000 or more shares) that happens on the first day of trading is positively correlated with the long-term performance of the stock price. This means that flipping on the first day of trading is lower for hot IPOs with positive long-term returns and higher for cold IPOs with lower long-term returns.⁵ In other words, institutional investors are investing in and holding on to more secure investments with a positive expected return. The researchers that demonstrated this also speculated that this flipping behavior is likely tied to the mispricing of IPO stocks out of the gate. The IPO stock price often isn’t fully adjusted to market value at the time of the IPO, leaving room for flipping to help work out the fair market price.

The data surrounding flipping makes sense when we consider that large, institutional investors have more pooled experience, and a different set of incentives than individual investors. Because of this, institutional investors tend to be more representative of the predictable, rational investor in their approach to pricing and trading IPO stocks. This is likely why the flipping activity of institutional investors continues to be a significant predictor of stock price performance for the entire first year of trading.

Another important consideration is the type of investment that investors are trying to make. Research has demonstrated that on average, stocks with a high level of idiosyncratic volatility have negative expected returns. This is counterintuitive because normally higher systematic risk investments are priced according to their level of risk. In this case, the data indicates that some investors are not investing in positive expected returns. Rather, they are investing in the skewness of a stock. Researchers Boyer, Mitton, and Vorkink showed the following in their research.

“[The] results suggest that investors might pay a premium […] because a high level of idiosyncratic volatility is a good indicator of stocks that offer a high level of future skewness exposure. Unwanted risk (volatility) signals desired opportunities (skewness), and skewness-preferring investors may be willing to accept a stock with higher idiosyncratic volatility and lower expected returns in return for a chance at an extreme winner.”⁶

In other words, some investors have a propensity to approach investments with the same mentality as they might a lottery ticket. They may know that the risk of an investment is high and that the expected return is negative. However, the possibility of a substantial payout if the investment does succeed is attractive enough for rational people to invest regardless. Because many IPOs are positively skewed, some IPO investors pay prices for IPO stocks that are not normally considered logical because they hope they are investing in the next Apple or Microsoft. In the end, the companies that become overvalued by these investors will decrease in value as investors realize they have not “won the lottery.”

2. Firm Attributes and Underperformance:

In addition to investor behavior, IPO underperformance has also been linked to several key company attributes. The most influential attributes include the size of the company and whether the company is backed by a venture capital firm. These factors are so significant that research by Brav and Gompers (1997) shows that the overall negative abnormal performance of IPO stocks is due almost entirely to poor performance of small non-venture-backed firms.⁷ Smaller, less experienced firms are more likely to fail or falter within the first few years of their IPO. The failure of these firms has been determined to be a leading cause of the underperformance of IPO stock prices.⁸

Researchers have postulated that small IPO companies underperform for a variety of reasons, including greater sensitivity to economic shocks and the greater likelihood of asymmetric information. Smaller companies generally have a harder time surviving significant economic shocks because they lack the financial resources to recover. Researchers have also postulated that it is possible that large, rational investors pay less attention to smaller, higher risk companies going through the IPO process because they have less promise. Because of this, there is greater potential for important information to be overlooked which can cause overvaluation, especially in hot IPO markets.⁹

In addition to company size, venture capital backing plays a significant role in the long-run performance of IPO stocks. In general, venture-backed firms tend to outperform non-venture-backed firms in terms of stock price performance. Venture capital firms not only provide capital, but also experience and management expertise.¹⁰ In addition, venture capital firms also strive to maintain a good reputation for investing in worthwhile companies. Thus, having venture backing is a clear signal to the market that a company has significant future potential for growth and success.

If the research is so clear that small, non-venture-backed IPOs are the cause of underperformance, why isn’t this being priced into the market? This question is answered in large part by the methods researchers used to calculate returns. Researchers have clearly shown that the use of value-weighted portfolios substantially decreases the amount of IPO underperformance in relation to benchmarks, while the use of equally weighted portfolios make the underperformance much more pronounced. This makes sense as well given that the smaller, less valuable companies in our analysis are the most likely to underperform and have less influence in a value-weighted portfolio but relatively more influence in an equally weighted portfolio.

While we would expect the risk factors of small companies to be evaluated when investors are deciding what to pay for an IPO, small companies can do some things to try and prevent stock price underperformance. For example, small companies should be careful not to overplay their success. Many companies go public during a peak in growth and revenue. These companies often project they will continue to perform, when in reality they are not yet ready to sustain that level of performance. When IPO companies subsequently miss targets or perform poorly, their stock prices will fall. In these cases, even Day One winners can become long-term losers. Small companies should be particularly careful to recognize the greater risks they inherently face and plan accordingly. There will always be some risks in running a small business, but when properly managed, small company IPO stocks can still perform well.

3. Firm Behavior and Underperformance:

In addition to investor sentiment and firm attributes, certain firm behaviors have also been shown to increase the likelihood of long-run IPO underperformance. These behaviors include decisions such as the use of IPO funds and the propensity to engage in new acquisitions. When made incorrectly, both of these decisions can lead to operational underperformance, which then leads to stock price underperformance. Companies should approach these types of decisions carefully so they can maximize their internal efficiency and continue to drive positive returns for investors after an IPO.

As previously noted, firms often carefully time their IPO to achieve the maximum market valuation. One way to achieve a higher valuation is to wait for a hot IPO market. Timing an IPO in this way helps the firm capture higher initial stock prices and raise more money. However, market prices will trend down once the optimism dies down, putting downward pressure on stock prices. In addition to the market pressure, it is possible that the company doesn’t have a specific plan for the capital they raise. This means that the company may miss out on opportunities it would have been able to pursue if it had used the capital efficiently. Researchers have shown that a company’s intended and actual use of IPO funds can have a significant impact on their IPO stock price prospects, as well as on long-term operational performance.^{11 12} For example, research has shown that companies which state in their prospectus that their intended use of capital is to repay debt tend to underperform in the long run. This trend seems to suggest that firms shouldn’t go public just to take advantage of a hot market; rather, companies should go public when it makes strategic sense both in terms of valuation and the intended use of IPO capital.

In addition to hot market timing, many founders or firm insiders will attempt to time the IPO when the firm is cast in the best possible light in the public’s eye. This means that if insiders know positive information is going to be released in the near future, they will wait to go public until that information is released. In other words, just like companies wait for hot markets, they will also wait for optimism for their own firm to reach its peak. This means that, like we saw with hot markets, after optimism has peaked, we expect a downward pull towards more realistic prices.

In addition to waiting for market optimism, many companies may try to create market optimism around their performance by engaging in certain behaviors. One concrete example is highlighted by the research of Teoh, Welch, and Wong (1998). These researchers demonstrated that issuers that window dress their prospectus (i.e., use accounting standards to report higher levels of earnings by manipulating accruals) “have poorer stock return performance in the subsequent three years.”¹³ In other words, some IPO companies are using generous earnings management around the time of their IPO and in the periods immediately following. This behavior appears to lead to higher valuations by investors who are optimistic about the increased—albeit superficial—momentum in earnings. While this might give the company a higher valuation in the short run, stock prices will eventually adjust downward when the company releases more information that shows its growth was not sustainable.

Another firm behavior that has been linked to IPO firm underperformance is the tendency for new IPO firms to engage in acquisitions soon after the IPO. This behavior was pointed out by Brau, Couch, and Sutton (2012), who demonstrated another potential downside of investor optimism. High investor optimism can make owners and managers overconfident in their ability to make correct decisions about acquiring new firms. Acquisitions are very difficult to execute effectively, and often lead to periods of poor performance. This is clearly reflected in the research which shows that IPO firms that execute an acquisition within the first year are much more likely to experience negative abnormal returns.¹⁴

4. Industry Trends and Underperformance:

In addition to the behavior of the investors and firms, industry and overall market behavior also play a significant part in IPO underperformance. Researchers have shown that certain industry/market conditions appear to prompt higher levels of investor optimism. The data show that six months of “a bullish stock market […] encourages IPOs activities” and two years of negative trends may have the same effect.¹⁵ It is also the case that firms within the same industry will often go public in clusters once they see that other firms in the industry are getting high valuations. Firms should consider how their decisions will impact not only their funding opportunities, but also the market environment in which they compete.

Researchers have noted that IPOs can have a significant impact on their related industry. Often, the inherent characteristics of an IPO can cause poor industry performance. For example, IPOs often reveal large amounts of relevant information about companies and industry prospects. This information could lead to increased competitive pressures throughout the industry. One study of 2,483 IPOs showed that the IPOs were “followed by negative industry share price performance levels in the 3 years following the IPO.”¹⁶ These same researchers postulate that this is either because IPOs increase competitive pressures within an industry or that industry valuations have already reached their maximum during hot markets and thus have nowhere to go but down.

Researchers have found several factors relating to IPOs that have significant effects on industry valuations.¹⁷ These factors include the size of the IPO relative to its industry, current IPO volume in the market, and the level of regulation in the industry. Smaller companies and companies in regulated industries each raise competitive pressures by going public, which may decrease industry valuations. Overall, researchers have shown that “the magnitude of industry effects following the IPO is conditioned on industry valuations […] and the competitive characteristics of the industry at the time of the IPO.”¹⁸

Conclusion and Key Takeaways

One could argue that the tendency for some IPO firms to underperform their benchmarks may be a positive sign that firms are timing their IPOs well and capturing the overoptimism of investors during hot markets. However, research on this topic has revealed that there are specific factors that can predict and explain abnormal stock performance for IPOs.

The insights that researchers have uncovered in their attempts to explain the negative abnormal performance of IPO stocks can help investors and companies make better decisions. Investors can avoid lower quality IPO investments by acknowledging their tendency to act irrationally in hot markets or when approaching investments like lotteries. Companies can achieve greater operational and stock price performance in the long run by mitigating for risks and avoiding behaviors like investing in unnecessary acquisitions. By accounting for industry and market dynamics, firms can also increase their chances of competitive success. Ultimately, firms and investors that have a greater understanding of the causes of long-run IPO stock price underperformance will be more prepared to create and sustain long-term success.

Resources Consulted

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