Initial Public Offerings (IPOs) allow private companies to issue shares to the public and raise capital from public market investors. The process is highly regulated and capital-intensive. In recent years, investor demand for newly issued shares has driven sky-high valuations, making going public attractive for founders as well as early investors seeking an exit. Last year was a record one for IPOs, many of which are late-stage high-growth firms e.g., Robinhood, Rivian, Coinbase, and Coupang. In total, firms raised over $150 billion in proceeds in 2021.

In crush for time

Recently, more firms have chosen to go public via reverse mergers with special purpose acquisition companies or “SPACs”. These are dormant blank check companies that exist solely on paper, raising capital from public investors for the purpose of merging with a yet-to-be-decided private firm in an effort to bring it to market. This unconventional approach, which picked up pace in 2020, is much faster than the traditional process with regards to regulatory hurdles and also less expensive. However, SPAC mergers come with fewer operational and financial disclosures. Of the 1,026 public listings last year, about 60% percent were via SPACs, and those listings raised over $160 billion in 2021 alone.

For the record

Regardless of how companies come to the public market, investing in recently-public firms has generally not been accretive for investors in the long run. While big “first-day pop” pulls investors, the fact is that most IPOs underperform. Analysis by Prof. Jay Ritter and team, dating back from the 1980s through 2019, shows that the average 3-year market-adjusted return of IPOs was about -16%. And WSJ report highlights that 2021 was no different. In short, excess optimism/greed by market participants generally drives overvaluations in the short term, only for the stocks to cool off later. Not to pick on one firm but a recent example is EV Maker, Rivian, which went public in early Nov 2021, raising $12 billion at an $86 billion valuation—more than Ford Motors—despite having less than $1 million in projected sales and over $1 billion in losses. Today, under six months later, it trades at an over 60% discount to its IPO price. For us, we have historically shied away from investing in new issues for key reasons:

• Lack of profitability: A recent NASDAQ study found that today about 80% of recent IPOs were by unprofitable firms, compared to 20% in the 1980s. Notably, today’s ratio is reminiscent of the dot-com era. Not a good sign if you are looking for long-term returns.

• Lack of track record: Although the median age of firms at the time of IPO is a little over a decade (11 years to be exact), most firms only disclose the required three years of audited financial statements in their S-1 filings. For us, this is typically insufficient to assess the operational performance and/or durability of the business moat for most firms.

• Hype train & investor exuberance: As noted above, researchers have found that IPOs tend to underperform over a 3-year horizon. The fact that this is systemic reflects investor behavior consistent with early hype. For instance, in their S-1, Rivian prominently highlighted Amazon’s initial pre-order of 100K commercial vehicles as well as over 48,000 consumer preorders; just enough to match the 150K estimated production capacity. Whether or not this materializes is irrelevant. The messaging was clear: a prospect of strong demand!

To us, “A bird in the hand is worth two in the bush”. And in light of clear evidence that most IPOs underperform in the long run, we generally shy away from hot-new listings—many of which are unprofitable hype trains. Instead, we focus on a collection of businesses with a proven track record of operational excellence.

The Xantos Team