The Dangers of Initial Public Offerings

If there's a time when investors often turn off their reasoning and fundamental analysis skills, it's with initial public offerings (IPOs). With an IPO, a company that had been private offers its shares to the public for the first time. There's often a great deal of hoopla and excitement when a company's shares are in the public's grasp.

Some investors love to buy IPOs, practically sight unseen. It's not because there's a lack of information on IPO. Companies going public for the first time must provide everyone interested in investing with a regulatory filing called the prospectus. A prospectus is a gigantic file of regulatory disclosures that are kind of like the 10-K, 10-Q, and proxy statement all rolled into one. Prospectuses contain all the financial statements you could ever want.

But often, new companies coming public have such a positive story, investors can't seem to help themselves. Here's a startling fact: A huge number of companies aren't even profitable when they're launching their IPOs. In 2014, for instance, 83 percent of all technology companies launching an IPO lost money, says Jay Ritter, professor of finance at the University of Florida. It's not a recent phenomenon either. And get this: Back in 2000, 80 percent of the companies that sold stock to the public weren't profitable. Investors, though, routinely ignore the fundamentals and buy these IPOs anyway.

As you're probably guessing already, investors who buy IPOs with no understanding of the fundamentals are usually sorely disappointed. Investors who bought IPOs between 1980 and 2013, and held the stocks for three years, wound up lagging the rest of the stock market by 18.4 percent, Ritter says.

Some IPO wipeouts are especially stunning. One that comes to mind is Etsy, an online retailer where artisans can sell handmade items that sold shares to the public for the first time in April 2015. Online companies were the hot thing again on Wall Street in the mid-2010s, as investors saw the success of Amazon.com and hoped to get on the ground floor of the next hot online retailer. Etsy soared 88 percent on its first day of trading to close at $30 a share. But, again, investors doomed themselves by paying top dollar for a risky business. The company's losses continued to accumulate in 2015, and Etsy shares sank to roughly $9 a share in December 2015 for a crushing 70 percent loss for investors who bought on the stock's first day.