The Little Book of Stock Market Profits: The Best Strategies of All Time Made Even Better by Mitch Zacks
Author:Mitch Zacks
Language: eng
Format: epub, pdf
Publisher: John Wiley & Sons, Ltd.
Published: 2011-10-14T21:00:00+00:00
A Chance at Profiting
So if you should generally avoid IPOs—and especially avoid non-venture-funded IPOs—is there any way you can use IPOs to try to generate excess returns? The answer, very interestingly, lies with potentially using the aggregate level of IPOs as a means of gauging the market’s overall frothiness. Periods when companies are issuing large amounts of equity are generally followed by periods of low overall market returns. Conversely a period consisting of a dearth of IPO activity generally results in a strong equity market for the next half-decade.
This makes a certain amount of sense, since private companies are more likely to go public when there is more demand for publicly traded equities than there is supply. This supply imbalance occurs primarily when the demand is overheated because of run-ups in stock prices. Another potential explanation is that the pattern is caused by the managers of the private company being able to time their equity issuance to coincide with what they see in real time as market peaks. Companies sell shares only when investors are willing to pay through the nose for them.
Imagine a company looking to finance growth. The managers of the company have the option to finance the growth by issuing either debt or equity. They will likely choose to issue debt if the market value of the debt issued is higher than what the managers think their debt is truly worth. Similarly, the managers will issue equity when they feel that the price paid by the public for the equity they are issuing is greater than what the equity is intrinsically worth. Effectively, managers issue equity when their equity is expensive. This produces an interesting signal: If many companies are issuing equity either through initial public offerings or secondary offerings, it may be an indication the market is overvalued.
Additionally, when the percentage of equity issuance starts to increase dramatically relative to the historical level of debt issuances, it is an indication that the insiders who manage the companies in aggregate see the market as expensive. The time you want to buy stocks is when the managers of the companies don’t want to part with their shares. The good news for investors today is that we are likely in such a period, and the dearth of IPOs and secondary equity offerings indicate the market may be heading higher over the next half of a decade.
An important caveat is that the IPO underperformance results are not uniform across studies or sub-samples of firms. Like many of the strategies we have looked at in this book, the IPO results do not hold for all periods. Consequently, there are several periods when IPOs substantially outperform the market. Also the results do not hold for every single company, and the media tend to focus on the winners and ignore the losers. It is relatively easy to fall into a lottery ticket mentality by dreaming of participating in the next Google, but the reality is that on the whole, statistically, IPOs do not make good investments.
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