IPOs That Double At Debut Usually Dive InThe Long Run, Says UF Expert

March 19, 1997

GAINESVILLE — Hot new stocks that double in price on their first day of trading often end up losing money in the long run, according to a new study by a University of Florida finance professor.

Initial Public Offerings, or IPOs, are issued when a company first sells its stock on the market, or “goes public.” IPOs have gained a higher profile recently because of companies whose stock prices doubled on the first day of trading. Examples include restaurant chain Boston Chicken and computer software makers Yahoo! and Netscape. These are just three of the 21 IPOs that doubled on their first day of trading, according to the study by Jay Ritter, a leading expert on IPOs. After the first day, however, 18 of these stocks have underperformed.

“From the closing market price on the first day of trading through March 17, the average loss on the 21 IPOs that doubled their stock prices on the first day of trading has been 34 percent,” said Ritter, the Cordell professor of finance at UF. “This is in spite of the fact that the broader stock market has gone up over 60 percent since August 1993, and by more than 10 percent since the most recent of these hot issues was offered in June 1996.”

Companies usually see their stock price jump when they initially go public.

“On average, IPOs jump 15 percent on the first day of trading. But just as some double on the first day of trading, others may actually drop,” Ritter said. “For example, CB Commercial Holdings, a Los Angeles real estate services company, sold 4.3 million shares last November at $20 per share, and the price immediately dropped to $19.”

Even if an investor could predict which IPOs will double on the first day, it still would be difficult to make money.

“The problem is that hot issues are in heavy demand and therefore difficult to get at the offer price,” Ritter said. “In contrast, IPOs such as that of CB Commercial Holdings, are easy to get. And, as the long-run evidence shows, it is dangerous to buy the hot issues after the price has already jumped.”

So why have the hot IPOs done so poorly?

“First, 16 out of 21 of these hot IPOs were in the computer software or hardware industries, and many of these stocks have fallen out of favor during the last year,” Ritter said. “Second, investors were exceedingly optimistic about all of these companies. To live up to such lofty expectations, everything had to go right. Unfortunately, that rarely happens.”

Small investors hoping to buy stock when one of the hot issues goes public likely would be left out of the game.

“It’s nearly impossible for small investors to buy the hot stocks,” said Tim Loughran, a finance professor at the University of Iowa. who researched IPOs with Ritter. “When a company like Netscape goes on the market, a company that everybody knows is going to do well, there is almost no hope of a small investor getting this. They are only going to get the dogs.”

Loughran and Ritter published a study in the Journal of Finance that found the average stock underperformed other stocks by 7 percent per year in the five years after the first day of trading.

In the financial community, there is extensive publicity that IPOs are poor long run investments. But the research is not as well known to the general public, which means the inexperienced should be wary.

“If you are an investor with limited money, this is not a game you should be playing,” Loughran said. “An example I like to use is in the movie Forrest Gump. The stock he bought, Apple went public in 1980. If he had held on to Apple stock for five years he would have actually lost 30 percent. This is part of the public’s perception of the IPO market.”