Sunday, August 26, 2007

IPO Investors, Beware!

For the past several months, a close friend of mine has been salivating about the upcoming IPO of VMware (NYSE: VMW). He thought that it would be a great investment opportunity. He even tried, unsucessfully, to get some shares at the IPO. VMware finally went public earlier this month in a wildly successful offering. Turns out that my friend was right. The IPO was an excellent investment opportunity. My friend invested at $55 a share, so as of Friday evening his investment certainly paid off (the stock closed at $71.30).

However, not all IPOs have a happy ending. In fact, a number of academic studies have shown that for the first 3 to 5 years after an IPO, shares of newly public companies tend to underperform the general market. See for example this article, and this excerpt. This is such a well known phenomenon that I first heard about it when I took my very first finance class in business school.

My friend did very well for himself, but I am not clamouring for a share of that pie. In fact, I am going to stick to my tried and true indexing strategy and not try to outperform the general market. While my friend seems to have beat the odds so far, on average he is playing a game that is stacked against him. Remember, some people also win money at the slot machines, at the roulette table or by playing their state lottery, but that doesn't mean that playing those games is a prudent investment strategy.

Thanks for the offer, but I'll take my equity investments slow, steady and well diversified.


Anonymous said...

The comparison with a lottery or other game of chance is a surprising one. A player in a game of chance has no information other than that the odds are against her. A buyer in the stock market has or ought to have substantial information beyond remembering that most IPOs fizzle; buying an IPO is indeed risky, and VMW may yet fall back to earth.

Still, you might want to ask your friend whether there was information available about the company before the purchase, and if so, what it was.

Shadox said...

Well, that's exactly it - since everyone has the same information, no one has any advantage. The price at any given moment is just as likely to go up as it is to go down. This is a bit of an over-simplification, but this phenomenon is known as the efficient market theory, it is has been shown to be very effective in repeated studies.

Eric said...

I think this is a great post. I've worked with a few ppl that used to work at IPO's. One of them left with 100,000 shares of the company. The only problem is the company tanked shortly after they went public. The investors took their cut, the board theirs, the executives theirs, and the company never turned a dime.

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