After a strong 2013, the IPO market continues to be hot this year. High investor demand, low interest rates, rising stock market and improving economy are the main reasons driving the IPO boom. Investors are now much more willing to invest in these fledgling companies, in anticipation of high rewards later.
Some of the highly anticipated IPOs continue to feed the frenzy. The most hyped IPO event this year undoubtedly is the US stock market debut of Chinese e-commerce giant Alibaba. The IPO is likely to be one of the largest in history with an expected valuation of ~$130 billion. (Read: 4 ETFs to Tap on upcoming Alibaba IPO)
Strong Momentum in the IPO Market in 2014
49 deals have been priced so far in 2014, up 81.5% from the same period last year and proceed raised ($8.0 billion) are up 24.2% from last year, according to Renaissance Capital. That is a strong rebound from the lows seen in 2008, at the height of the financial crisis, when just 31 companies went public.
Looking at the industry breakdown, Healthcare has seen the most offerings (26) this year though the rise has been spread out across various industries. This is nice change from the dot-com bubble days when the IPO space was totally dominated by the tech companies. (Read: 3 Top Ranked ETFs from hottest sectors)
Are all IPOs successful?
Investors hoping to profit from this surge should however remember that not all IPOs are successful. While a handful of these fledgling companies may turn out to be excellent investments, some may result in big losses.
If you have excellent skills in picking newly public companies, which may later turn out to be like Google, Apple or Tesla, then individual IPOs are the best for you.
But actually investing in smaller, rather unknown companies can be quite risky. 74% of companies that launched IPOs in the last six months have lost money, highest from March 2000, when 80% of new companies were unprofitable.
Further, some valuations are now touching crazy levels. Castlight Health, which debuted last week, now has a market value of $2.7 billion, though it had revenues of just $13 million last year and will not report any profits in near future. At its current price the company has a whopping P/S ratio of 181.8. (See: 2 Rising ETFs with double digit yields)
On the other hand, median IPO in 2014 through February was priced at 14.5 times revenue—which itself is the highest in 14 years.
Case for Investing in IPO ETFs
Most investors should consider IPO ETFs that provide a low-risk and diversified exposure to IPOs, instead of betting on individual stocks.
With their sharp focus on the largest, most liquid and best performing offerings, these ETFs have been handily beating the market.
IPO ETFs provide exposure to newly public companies before they join other core US equity indexes. Most broad market indexes include newly public companies only after a ‘seasoning’ period—i.e. after they have been trading for some time. For example, Google was included in the S&P 500 index about two years after its debut.
Investors should however note that they will not be able to capture the first day’s ‘pop’ (or drop!) with these ETFs, since they include the newly public stock only after it has been trading for a few days.
Though IPO ETFs do not participate in the first day’s ‘pop’, this strategy reduces their volatility. Many retail investors had suffered losses in Facebook IPO, one of the most hyped IPOs of all times, which fell substantially below its offer price within the first week of trading itself, but recovered a lot later.
Many investors probably still remember the disastrous performance of some of the ‘hot’ IPOs from the dot-com era. An ETF approach can largely reduce the risks, while offering the opportunity to participate in the gains of a diversified group of larger, more liquid IPOs.
First Trust US IPO Index
FPX tracks the IPOX-100 U.S. Index, which is a modified value-weighted price index measuring the performance of 100 largest, typically best performing and most liquid U.S. IPOs (including spin-offs).
Currently, the product has a nice mix of sectors, with top four being Consumer Discretionary, IT, Energy and Healthcare. In terms of individual holdings, Facebook (11.0%), AbbVie (8.7%) and General Motors (6.9%) take the top three spots.
With a 10% cap on all constituents, the fund rules out too much concentration in any single holding. The ETF, which was initiated in 2006, has managed to attract about $570 million in assets so far. It charges annual expenses of 60 basis points.
The product has crushed the broader market over the last five years, returning 288% compared with 170% for SPY.
Renaissance IPO ETF
IPO tracks the rules-based Renaissance IPO Index which is comprised of the largest and most liquid newly-listed U.S. IPOs. New companies are included in the index on the fifth day of trading or during quarterly review. They are removed after two years.
Zoetis, Facebook and Workday are the top holdings as of now. This ETF is more top-heavy compared with FPX, with top ten holdings accounting for almost 60% of the asset base. The fund charges an expense ratio of 60 basis points.
The ETF was launched recently, but has been handily beating the broader market since inception.
The Bottom Line
The IPO market is booming this year. But investing in new, untested companies can be risky. ETFs provide a low-risk and convenient way to profit from the IPO boom.
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