Initial public offerings (IPOs) are back on the menu. Across the pond, shares in software company Snowflake are white-hot. In the UK, e-commerce firm The Hut Group has just joined the market. After what happened with luxury carmaker Aston Martin‘s (LSE: AML) share price, however, I’d be wary of getting involved too soon.
Aston Martin: an IPO car crash
Aston Martin accelerated on to the scene to great fanfare in October 2018. Shares were priced at £19 a pop, valuing the business at an astonishing £4.3bn. Unfortunately, a toxic combination of falling sales, increasing losses and the arrival of the coronavirus sent the shares crashing. Those who were early to this ‘party’ would now be sitting on a loss of around 90%.
Could this have been predicted? There was certainly a red flag or two. The fact that Aston Martin had already gone bust seven times in its history was hardly comforting. There are, however, a few more general reasons why it’s usually best to stay away from IPOs.
You’re buying what someone doesn’t want
In the midst of an exciting new listing, it’s easy for investors to forget that the opportunity to buy is only there because someone else is wanting to sell. Naturally, this seller will also want the best price they can get.
A high asking price for shares at an IPO is problematic for investors because it increases the likelihood of a company lagging the market once the hype dies down. Remember that traders will be buying in the hope of ‘flipping’ their shares soon afterward, hopefully at a big profit.
As a result, a lot of companies only go to market when the mood feels right, not necessarily when they’re making good money or have no debt. Go back to the dotcom bust at the turn of the millennium and you’ll find lots of businesses that weren’t making any money at all!
Of course, this isn’t to say some stocks won’t spring back to form eventually. Shares in social networking giant Facebook famously plunged in value when they came to market, partly over concerns the company might not be able to monetise its platform. Fast-forward eight years and Facebook is now one of the biggest firms in the world.
What I’d do instead
For the reasons mentioned above, I think it’s usually best to avoid buying newly-listed shares. This is the case even if the price rockets on the first day, as happened with Snowflake recently.
Instead, I’d use the time to conduct some thorough research. For starters, find out who’s selling and why. Could it be because they want to cash in on the hype surrounding a particular product or service that will likely prove temporary? Also, check whether they still intend to hold a significant stake in the company post-IPO. Andy Bell — founder of broker AJ Bell — is a good example of this.
In addition to this, it’s also worth comparing a company’s valuation at IPO to that of another business in the same industry. If there’s a notable difference between the two — and no clear reason why — it’s probably best to steer clear. Aston Martin’s IPO share price was even more ludicrous compared to luxury rival (and profit-making) Ferrari’s valuation, given the former’s questionable track record of managing its finances.
Randi Zuckerberg, a former director of market development and spokeswoman for Facebook and sister to its CEO, Mark Zuckerberg, is a member of The Motley Fool's board of directors. Paul Summers owns shares of AJ Bell PLC. The Motley Fool UK owns shares of and has recommended Facebook. The Motley Fool UK has recommended Snowflake Inc. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.