The imminent listing of Alibaba Group Holding on the New York Stock Exchange will mark the largest initial public offering (IPO) in history.

The imminent listing of Alibaba Group Holding on the New York Stock Exchange will mark the largest initial public offering (IPO) in history.

  The big Chinese e-commerce outfit will sell up to $24 billion in shares, and the market value of the firm will approach $200 billion. Many a frenzied investor is trying to decide whether to hop aboard at the IPO price or wait until the stock trades and excitement surrounding this historic offering settles down.

The public offering of Alibaba is a 21st century version of the China consumer dream. For centuries, merchants have dreamed of conquering the consumers of the world’s most populous country (current population: 1.4 billion). At the dawn of the industrial revolution in the 18th century, the British imagined that the textile mills of Manchester would whir forever if they could just “add an inch of material to every Chinaman’s shirt tail.” In the early 20th century, Standard Oil’s John D. Rockefeller dreamed of supplying “oil for the lamps of China.” In 1937, Carl Crow, an American who opened the first Western ad agency in Shanghai, published a best-seller about the market entitled “400 Million Customers.”

So back to today, should an investor purchase shares of Alibaba? We have no opinion on the stock or the fairness of the offering price. But we have conducted extensive research on the history of IPOs, their pricing and performance subsequent to listing on the market, and think the results of that research could be helpful to investors contemplating such a purchase.

Is the IPO price fair?

Underwriters often set low offer prices, leading to high first day returns when IPOs are initially traded on an exchange. Given the potentially high returns earned by investing in IPOs, should an investor buy IPOs from an underwriter at the offer price?

For the price to be fair, two requirements need to be satisfied:

Transparent information on the expected price at which a security is bought or sold
High expectation that securities can be bought and sold at that price
For public securities that trade on an exchange, the Bid reflects the market’s expectation for the price that a security can be sold, and the Ask is the price at which a security can be purchased. Market orders that are sufficiently small in size will be executed at or near the Bid and Ask prices. For an IPO, there is often a range provided by the lead underwriter for the offer price. The underwriter, however, can set an offer price that is outside of this range. Since the price is not known at the time an IPO deal is won by the lead underwriter, IPOs fail the first criterion for prices to be fair.

IPOs also fail on the second criterion. For an IPO where demand for shares exceeds supply (aka “Hot Issue”), the amount of shares you submitted as an indication of interest to purchase will most likely not be available for allocation to you if the supply of shares available is not sufficient to meet demand. Thus, while an investor will still benefit from a high initial day return, he will often not get the number of shares requested, thus reducing his potential profits. For an IPO where demand is less than supply, your indication of interest will most likely be allocated in full, but in many of these cases the price falls on the first day. The potential lack of a fair price and the non-transparent nature in which IPOs are allocated make it difficult for an investor to know whether the potentially high initial day returns to investing in an IPO are in fact achievable.

Are IPO stocks good long-term investments?

A second, related question is whether IPOs are suitable investments after a firm has gone public and shares are being actively traded in the market. Executives and owners of a company that has an IPO are subject to restriction on trading their shares of the company. In many cases the restriction or “lock up” period to sell their shares of the company stock may be six months to one year after the trade date of the IPO. When this lock-up expires, however, our research has shown that in many cases the share price declines in value for these companies as the insiders are now able to sell their shares in the open market.

IPOs, historically, are often for companies that are smaller and more growth-oriented than the established companies listed on an exchange. Prior academic research shows that historically, small growth stocks have had poor performance. To control for size and value characteristics, each month we compared the return of an IPO firm to the return of firms that have similar Size and Book-to-Market ratios. We then divided IPOs into three groups by their market capitalization: Microcap, Small Ex-Micro, and Large. The results were reported in the time period following the IPO. The abnormal returns (return minus size/value-matched benchmark) for IPOs were averaged across all IPOs in that size group. For example, quarter six for Microcap is the average abnormal return six quarters (or one and a half years) after the firm has gone public and reflects all IPOs. The cumulative performance since the IPO (Quarter zero) is displayed in the line chart below.

Conclusion

Our findings suggest that, while first day returns for Hot Issue IPOs are quite high, they are unlikely to be achievable for investors because they are unable to get the shares they indicated for due to oversubscription. Additionally, IPOs historically have underperformed for up to two and a half years after going public. For these reasons, we believe, that despite the allure of trying to buy an IPO, the costs and speculative nature outweigh the benefit for an individual investor.

Gregg S. Fisher, CFA, CFP® on LinkedIn