Do IPOs Have a Place in Your Portfolio?

Welcome to "The Informed Investor." I'm Jake DeKinder and very pleased to be joined by my colleagues, Dr. Wes Crill, Dr. Kevin Green, and these are my colleagues here at Dimensional. We're a global asset manager managing over $850 billion under management. And I got two doctors on the program today. You do. A lot of doctors. I'm surprised you didn't wanna sit in between us. So you had us book ending you. That would've been better. That would've definitely been better. I definitely feel a little bit inadequate, to be clear. Reminder, if you have a true medical emergency, we cannot help you. My wife says that, she's a professor over at UT and she makes that joke all the time. Which, it never, never gets old. But today guys, we're gonna be talking about IPOs and I think that's on a lot of investors' minds. I'm gonna start with a couple of headlines here that I grabbed from a recent period here. The first one, "IPOs are Hot Again. How Investors Can Avoid the 2021-Style Hangover." And then another one here that's interesting "How Retail Participation in the IPO Market Is Transforming the Stock Market." So Wes, I mean, what's your take on those? That's a nice juxtaposition where you have this exuberance around the current market and then a reminder about what happened just a few short years ago when, maybe people were more burnt by some of this craze around IPOs. So it's a good lesson, you know, like things come back in style all the time. Maybe IPOs are the next thing. Yeah, and we'll go back and we'll talk about a couple of periods here over the last several decades, but Kevin, just take on those headlines. Yeah, we see that from time to time where you have a company that comes public and they do really well, initial strong returns, and you see a lot of headlines and you kind of suggest that maybe all IPOs perform in a similar fashion or it's a part of your portfolio allocation you should be focused on. And what we'll see as we build this conversation, I think is that's not always the case. Yeah. Good to note there. Okay, so break it down for us. I'm a company and I want to go public. What are my options? What do I do? Yeah, Jake, there's a few pathways to making the transition from a private entity to a publicly traded company. And the most common one is through an initial public offering backed by an investment bank that underwrites the offering. They go around and do a roadshow, build up support and demand for the shares. And it's enacted through a primary transaction in which those shares are then offered to what we'll call a select group of individuals. Okay. And there's a transaction made and then they're listed publicly for the first time. And so those that were a party to that primary transaction can then have the ability to either sell those shares or hold onto 'em, assuming that they want to do so. But that selection process is something we can dive into later about what that means for most investors' ability to actually participate in that primary offering. And question for you, when you say individual, like a select group of individuals, should we really think maybe like a select group of entities? Is that maybe a better way to say it? 'Cause it's not always just like a person these things are going to, obviously. Absolutely right. You think of the investment bank as helping to grease the wheels, if you will, for this transaction. So they're going to meet with their clients and building up demand. So oftentimes these individuals, as I say, are actually institutions like banks. Institutional investors that are getting allocation to these primary offerings. Okay, makes sense. But there's other ways too. There are other ways too. Another way that a company can go public is through a SPAC transaction. Now there's multiple parts here. SPACs are what are called special purpose acquisition companies. Okay. So you see these shell companies go public or where they're commonly referred to as blank check companies. And the proceeds that they generate from that initial offering are then used to either merge with another company or acquire another company that then you have this de-SPAC event as they call it. I have a new operating company that's public. So if you're a private company, you can work with one of these SPACs if you will, to either be acquired by them or to merge with them and then transition to the public market accordingly. That's a pretty popular, currently popular, I should say. Historically we went through a pretty long stretch where these blank check companies were kind of non-existent. Right. The pandemic brought them back. That's what I was gonna say. I mean this term SPAC, some of our viewers may be familiar with. I do remember back coming outta COVID that it gained a lot of popularity was out there. I mean we got so many questions about SPACs back in 2021. Yeah. 2021, 2022. And it was interesting because you know, you have this belief about what kind of business they're gonna be acquiring. Probably how they were able to raise the capital in the first place is they'll say, "I'm gonna acquire X, Y, and Z technology company." A lot of 'em ended up not even acquiring something in the same industry in which they were promising when it came to raising the funds. So I know a lot of people probably forgot about 'em, but it's interesting that they're coming back around potentially. Yeah, I mean I go back to 2021, we got questions all the time. In fact, I think we recorded a video. I think you did a paper on this or we did a paper on that. I haven't gotten a question about a SPAC in the last three, three and a half years. Yeah, it's interesting. I think from an investor's perspective, there's two things to look at. There's the, a company that's looking to go public can go public through the SPAC, but also as an investor you see interest in investing in the SPAC before they've ever had a business combination. And it's a little bit of a crapshoot. You don't really know what ultimately you're gonna be invested in. It's kind of in the hands of the professional managers that are running the SPAC. So a little bit of a lottery aspect to understanding what your ultimate outcomes are gonna be before there's actual, a company to deal with. Okay, so second way, you just defined there. Yep. Other ways. There's one more way through a direct listing, and this one's pretty uncommon. I haven't seen a lot of activity in this regard, but what it is is the private shareholders, you can think of these as the company founders if you will. Okay. Rather than issue new shares, they simply list the existing shares on an exchange and that's called a direct listing. And historically it hasn't been involved with any additional capital raising and it's also pretty uncommon. There's been a few, Spotify or Slack, that people may have heard of. But by and large it's a small minority of the activities you see, of pathways to go public. Just outta curiosity, motivation for the original owners to do that versus something else, they just don't need capital, they don't need? It could be that they don't need capital, it could allow for a quicker transaction, and it could also alleviate cost of having to deal with an investment bank just by listing those publicly, you potentially gain access to liquidity as the shareholders without having to go through all the hurdles of a traditional IPO. Let's talk a little bit about IPO activity. What's been going on recently? I'm reading more and more articles this year about it and it felt like we were sort of in a lull for a while but now it kind of seems like it's been picked back up. So what's going on in the IPO market? Yeah, Jake, you've seen an uptick in IPO activity so far year to date, 2025, where we're close to, if not exceeding the full calendar year 2024 in terms of IPO activity, I've seen SPACs come back somewhat in vogue. So 2025 has been a hot year if you will, to use kinda the media terminology for IPO activity. And that's pretty consistent with kind of the natural ebb and flow of IPO activity we've seen historically. You go through these periods where, for example in the pandemic, where you see a really high level of activity, and then oftentimes you follow that, let's say following the great financial crisis where you see really low levels of IPO activity. So it's quite common to go through years with a really heavy dose of IPOs, followed by years in which it's pretty meager in terms of the overall IPO activity, It seems like there's a lot of hype around it right now. And Wes, we've talked on previous shows that, you know, anytime you sort of get this, a lot of excitement out there in the market, maybe as an investor you want to be a little bit skeptical of what's going on. It's true, I mean a lot of investors get FOMO if they read about something in the headlines and they're not personally invested in it and so they might have an attraction to it. One thing that kind of caught my ear when you were talking about some of these names that people would've heard of that did direct list, saying those are bigger firms. I often hear the claim that the IPOs these days are bigger companies than they used to be. There's a perception that a lot of 'em are large cap now. What do the characteristics look like of these when you look at the data? Yeah, Wes, if you read the papers, that's what you'll find. Are the large names, really successful, we'll call 'em unicorn companies, that go public, and all of a sudden they're either a large cap or in some cases a mega cap company right from the start. What you don't see in the papers is that the vast majority, and we're gonna say around 90% of IPOs fall into the small cap bucket. That trend is consistent when you look at IPO activity in the 90s to the 2000s today, it's something that's quite common and it makes sense, right? When a company's going public for the first time, I think you expect them to be in the smaller range in terms of the market capitalization compared to what's already out there. And that's true. You don't see the headlines that focus on those names. And for most investors you've probably never heard of them, but it's important to know that today's IPO market doesn't look different. It's not comprised of really large cap companies that have been around in the private space for years on end. What we see is the vast majority today are small caps and not consistent with what we've seen historically. On a previous episode we talked a little bit about valuations and we sort of broke down what does it mean for a company valuation, all those things. If you look at the IPO market, and we can stick with the small cap, since you said a lot of 'em are small cap, like what do you see in terms of valuations of these companies? Yeah, the valuations of these companies, and you can think they're trying to, you know, go public for the first time, build up a lot of interest in the shares, what we tend to find is that they have pretty growthy valuation levels. What that's also combined with- And we should say, growth is a high price relative to some fundamental. Exactly. So a high price to earnings, price to book. All of those, what you're gonna find consistently is that these land in the upper range of price to earnings or price to book, what we'd call a growth valuation. Another interesting characteristic that you find with these companies is that they have pretty poor profitability characteristics. So relative to their peers, they're generating less profitable outcomes on the, you see on their balance sheet. So when you look at that and you see, "Okay, I'm gonna be paying a premium, a high valuation for a company that's offering lower profitability," it's generally not the recipe for expecting that to deliver high out performance in your portfolio. Just quite common sense there. Yeah, and we'll look at some of the performance there, but I find that really interesting Wes, because you know, what we're thinking about here is, as an investor, what do I expect to make on an investment? And we know sort of what I pay and what I expect. There's a relation there as well. And so, you know, we start talking about smaller companies or small growth companies or small gross, you know, low profitability companies. We definitely have some research that says on expectation and actually actual returns, they have a little bit lower returns, don't they? Yeah, I mean, so just from a valuation theory standpoint, you think "Okay, I'm paying a high price, low profitability. Probably gonna be lower expected returns in the market." And we do have a substantial amount of research to your point, to show they have lower average returns in the market historically. And so then you connect that with the headlines where there's this excitement around investing in these companies and you think, "Well, are these actually higher expected return companies?" That I think to the data that you have, that might not be the case. Well it's interesting too, if you kinda take a step back and think about that, right? So I'm a company, I'm getting going, I've done fine, but maybe my products aren't fully baked, my profitability's not good, I got some work to do, but there's a lot of excitement around it. And so maybe, are people willing to pay, I'll say a lot, for kind of the potential for these companies, but it's not there yet? Yeah, you see that, I mean there's obviously a willingness to pay a premium for these companies, once they're newly formed public entities, but what is not supported by is that investors are rewarded for paying that premium. Okay. We see that historically when we look at companies that have low profitability, high growth valuations, but even more to the point when you just look at IPOs, historically, you see the headlines for this year suggesting that IPOs have delivered stellar outperformance. But internally we see that over the long run, post issuance, these IPOs tend to underperform. And that's consistent when you look at Dimensional, it's consistent if you look at the broader academic literature, every study concludes that after that initial one day return, you see IPOs, they tend to underperform. And so you the expectations of trying to remove from what you see in the newspaper and actually look at the data and see what it tells you, that's really where you want to inform your expectations and help inform your investment decisions. What about number of, I'll say IPO, like what are we seeing in terms of trends? Take me back, you know, several decades ago, the last decade, today, like what are we seeing in terms of number of IPOs? Another important question. Obviously this year has been a spike and we saw another spike around the pandemic. But what you see when you extend the horizon further back is that you see in the 90s there was a period of really high level of IPO activity. And then post the 1990s through the 2000s, and the most recent decades, what you've seen is a fairly sharp decline in overall IPO activity relative to what we saw in the 90s. And so what we see a lot of times is headlines or questions of "Has something changed in the market are IPOs today, not the frequency that we should expect them to be?" And it's a bit of a head scratcher to me 'cause they're pointing to a period where I think most of us would understand that maybe that's not the best era, the late 90s, tech boom, to anchor your expectations for IPO activity. And so I think with that there's been a lot of linkage from what we've seen in IPOs to maybe the performance of small caps because of that shift in the relative activity of IPOs. And a lot of that feel is largely unfounded. We get a lot of questions too, just number of companies in general. And then people do follow on and be like, "Well what does that mean for, you know, these premiums we discussed, small doing a little bit better." So I mean as we've looked into it, Wes, as we've seen in the US I'll say, and then we'll go international in a second, a lower number of companies either going public or maybe a lower number of small caps, what do we see in terms of, you know, expectation for small doing better than large over time? There's always gonna be that rush to do a post-mortem analysis on any premium that's been faring poorly. And in the US with small caps underperforming large caps over, you know, let's call it the last 20 years, people have been looking for those kind of stories. So you do see, you know, a drop in the number of companies publicly listed and people are trying to tie maybe to reduced IPO activity. There is an academic paper to suggest it's actually more M&A activity. So more companies are being acquired, not necessarily fewer that are IPO-ing, but you know, we've looked at these effects to see "Okay, is there a correlation between size, premium, observation, so the relative return for small versus large, and the frequency or the categorization of these types of events?" And we just don't see much of a correlation there. So it's one that kind of strains credulity in terms of explaining away the size premium that we've documented. There's a narrative that's out there, it grabs the headlines, but when you actually go in and look at the data and run the analysis, you're like "Yeah, that doesn't necessarily hold up." Yeah, Jake, I agree with, I mean what people tend to forget is on the heels of this .com era, the late 90s, where you saw a really high spike in IPO activity, what did we see in the subsequent decade? Where the number of companies declined, IPO activity declined. We saw really strong size premiums. That's a great point, great point. And so, when you look at the the data, what it really doesn't show you, is there any distinct relation there. And I like that anecdote to suggest just that, of we saw the S&P 500 underperform small caps over that subsequent decade when both the number of stocks in the US declined as well as IPO frequency going down. We keep talking about US here and we don't have to spend a ton of time on international markets. But if you look outside the US, what do you see in terms of anything you can comment on IPO markets or just number of companies? 'Cause we were just discussing that. Yeah, so outside the US you see a number of companies had continued to climb and you see IPO activity consistent with where it had been historically. But what you also see is similar trends in terms of IPO performance relative to what we see in the US. So the US has been a little bit unique relative to what we've seen globally in terms of stock counts declining or IPO activity not reaching the heights that it did in the 90s. But what we don't find is that any of that has any real merit of helping us form expectations for how small cap should perform. For example, if you look at a subset of US stocks and only take a subset of those and look to whether or not you might find a size premium, you do indeed find that. And then globally, when you look at all different market sizes across different numbers of stocks, which you find are consistently positive size premiums across the globe for countries that have a really large number of securities as well as those that have a fairly narrow market. Okay, so a couple of takeaways that I hear here is that, you know, this sort of like high activity of IPOs, fall off, it tends to ebb and flow a little bit over time. We can go back to the late 1990s. We look at coming outta the GFC there, in the 2010s. We look at 2020, 2021. We talked a little bit about that. And then what we're experiencing recently, right? But I think one of the big takeaways that I'm hearing from you is, is that when we look as a group in terms of the performance, they may not necessarily hold up their end of the bargain. Is that a fair way to think about it? Yeah, that's fair. And a good example is some of the index providers maybe in trying to capture some of the sentiment from the retail market, tend to rush to add new IPOs to their index. Yeah. And when you do a simple comparison of how those IPOs added to the index have fared in their first year post issuance compared to the index, you find that they underperform the overall index by over 150 basis points. That's pretty substantial. Yes. Yeah. Substantial. That's a monthly return there. So again, this idea of is there anything inconsistent with what we see historically? No, we see that live, whenever these IPOs are added to the index, we see that they're not adding value to clients in the way that people might expect based on headlines alone. Okay, one of the headlines that we did read here, Wes, had the comment about retail participation. And I think one of the things we try to do with this broadcast is educate people on "Hey, here's the things that you need to be aware of." So as you think about IPOs, like what do investors need to be aware of? What do they need to be cautious about? Well, we've talked about the performance, you know, certainly the history of these things underperforming the market. Another thing that was just occurring to me is it might not be the case that just because you've got an allotment to these IPOs that you can just sell 'em straight away to try and lock in that performance, right? So there's gonna be potential lockup provisions, it could be multiple months, maybe Kevin, you know, comment on that. I mean that's another element of a potential liquidity event that could be happening with these IPOs. Yeah, there's, in addition to kind of underwriter pricing support of and trying to ensure that the IPO is successful at the start, you also have these lockup provisions that the underwriter has in place to prevent, for example, all of the insiders from immediately liquidating their shares once the company goes public. But those lockups expire. And what you tend to find is there is indeed a liquidity event that can have a negative impact on IPO prices, when those provisions allow. You mean people may just be going out and as soon as it's over dumping their shares on the market. Yeah. And it can be substantial. Sometimes it can be over 50% of the total shares outstanding are locked up. And so you have this sizable event, which the supply of shares dramatically increases and as a result the demand needed to meet that supply oftentimes forces prices down. All right, great. Well guys, great education on the IPO market. Things we need to consider, what we're seeing with trends over time. So certainly appreciate you bringing up, being on the broadcast today. And thanks everybody for taking some time to tune into "The Informed Investor." We're actually gonna be on site at our Charlotte facility here in the next couple of weeks. We'll be talking with some financial professionals, getting their perspective on some different topics as well as hearing from Kevin Murphy, an academic that we have worked with over the years. And he's gonna have a great perspective on what's going on with the economy. So with that, thanks again for the time and make sure that you subscribe, hit that subscribe button, we'd love to have you tune in for more episodes. And have a great rest of the day.