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It's easy to fall for Silicon Valley's billion-dollar startups, getting caught up in the story of innovation and disruption. But think twice before you jump in head-first when they began finally trading on Wall Street.
2019 is slated to be a make-or-break year for those so-called unicorns, privately financed companies valued at more than $1 billion. After years of teasing, some of the most hyped-up unicorns are about to go public in the coming months through an initial public offering, including ride-hailing giant Uber, messaging software maker Slack Technologies and homestay booker Airbnb, just to name a few. And their valuations are eye-popping, with Uber leading the herd with a $120 billion target.
However, for average investors who would buy their shares in the secondary market, investing in unicorns is like buying lottery tickets — the chance of winning big is extremely low if you were not one of the lucky few to get allocated shares in the IPO. In fact, more than 60 percent of more than 7,000 IPOs from 1975 to 2011 had negative absolute returns five years following their first day of trading and only a handful produced extreme positive returns, according to a UBS analysis using data from University of Florida professor Jay Ritter.
"First-day returns aren't predictive for subsequent returns," UBS' head of asset allocation Jason Draho said in a note on Tuesday. "IPOs can be attractive investments if you can get an allocation, but much less so if you're buying in the secondary market."
Uber rival Lyft, the first unicorn to get out of the gate this year, serves as a reminder of how risky it can be for regular investors to buy hot IPOs in the open market. Shares of Lyft surged 9 percent on its debut, then sunk 12 percent on its second trading day to below its IPO price and have still struggled to bounce back. Skeptics have since got louder, saying buying the stock is "a leap of faith."
An IPO's initial pop tends to fade away as soon as six months after the offering when the lock-up period expires, freeing insiders to sell on the open market. The lockup prevents insiders from selling assets too quickly after the company goes public. From 1980 to 2016, the average six-month return for IPOs is about 6 percent or 2 percent excess return beyond the market, versus the over 18 percent average gain on the first day over the past 40 years, according to the data. More recently from 2000 to 2016, the six-month absolute and excess return has been both negative.
"After lockup expiration some investors, especially venture and growth capital investors, do start selling, which can put pressure on the stock price unrelated to fundamentals,"Draho said.
While it's a highly unpredictable market, issuers with some specific traits can stand out as winners. Companies with revenues over $1 billion and those backed by growth capital performed "far better" over three years, Draho pointed out, saying larger established companies are safer IPO bets.
"Investors should expect an active year for IPOs producing fairly typical returns, unless economic and market conditions turn unfavorably, in which case they best be prepared," Draho said.