It was the best of times, it was the worst of times … for initial public offerings (IPOs) on the US stock market in 2021, that is.[i] In terms of the number of offerings and dollars raised, IPOs had a banner year, with US issuance (including special-purpose acquisition companies, or SPACs, which are holding companies created for the express purpose of merging with a startup and taking it public) topping $300 billion (£222.3 billion) year to date—almost double 2020’s previous record, according to a Wall Street Journal report syndicated across several financial outlets we follow.[ii] Yet according to the Journal’s analysis, banner deals haven’t brought banner returns: Amongst the 384 US companies going public the traditional way this year, 255 are now trading below their offer price.[iii] An index tracking SPACs, meanwhile, is down -15.3% year to date and -33.1% from its mid-February peak, both in US dollars.[iv] In a refreshing turn, we aren’t seeing many financial commentators call this a repeat of 2000’s dot-com crash. But there is a school of thought amongst them arguing rising interest rates are the main culprit, allegedly making it less attractive to pay a premium for growth-orientated stocks’ future earnings. We think this is a stretch—one of many takeaways from IPOs’ 2021 boom and bust.
We weighed in on the lack of relationship between Tech stocks and interest rates a couple of months ago, and the same logic applies to interest rates and growth stocks in general—a point we won’t rehash here. More interesting, in our view, is how IPOs square with growth-orientated stocks’ overall returns this year, which are pretty darned good.[v] Growth-orientated shares generally have higher valuation metrics like price-to-earnings ratios and focus on re-investing profits into the core business to expand over time, making their profits relatively less sensitive to economic growth rates.[vi] By contrast, value-orientated shares, which dominate UK equities, tend to carry relatively lower price-to-earnings ratios and more debt, making them more sensitive to economic conditions. They also tend to return more money to shareholders via dividends and share buybacks versus reinvesting into the business. Growth is beating value by a smidge year to date—and by a mile since mid-May, when value’s brief rally (which we think was tied to vaccine cheer) fizzled out. It sure looks to us like investors are happy to pay a premium for future earnings regardless of interest rates’ wiggles.
Yet when you break growth stocks into small and large, a stark divide appears. Small-cap growth, the category our research shows many fresh non-SPAC IPOs fall into, soared during the first phase of the post-lockdown rally that began in March 2020, rising 72.9% from 16/3/2020 through that year’s end whilst large-cap growth delivered 55.0%.[vii] Both outperformed global stocks’ 42.9% return in that span, but smaller names were the clear winners—likely helping fuel enthusiasm for IPOs this year, just in time for that trend to reverse.[viii]
In 2021, small-cap growth is up just 11.7% year to date, badly trailing global stocks’ 24.3%, whilst large-cap growth is outperforming at 26.1%.[ix]
We see a simple reason for this: Stocks are behaving as our research shows they normally do late in a bull market (a long period of generally rising stocks), when investors increasingly seek the highest-quality companies. The high rate of companies going public this year is also consistent with a late bull market, according to our research. We have found that large- and small-cap growth companies share a tendency to derive earnings from long-term technological trends, and their fortunes typically don’t depend on the economic cycle’s ups and downs. But we also find that large growth companies tend to have an abundance of strong qualitative attributes, like a big global presence, strong brand names, diverse revenue sources, cash-rich balance sheets and—crucially—fatter gross profit margins, which are a measure of corporate profits before taxes, interest and other accounting manoeuvers. We think those have come particularly in handy lately as companies weathered higher costs and supply chain pressures.
In our view, the largest growth companies have much more of a buffer to handle this. They generally also have the ability to self-finance investment and future growth if bank lending slows, which could happen if the global monetary policymakers broadly raise short-term interest rates next year. New IPOs may grow into high-quality large companies one day, but for now, we think many are riding more on hope than strong cash flows, likely making them less attractive to many investors.
Another factor likely bringing IPOs’ disappointing returns is what we like to joke is an alternate interpretation of their acronym: It’s Probably Overpriced. When a company goes public, the goals are generally twofold: To raise money and to give early investors the chance to cash out. Both goals incentivise the investment bank coordinating the IPO to set the offer price as high as possible. If newly public companies deliver gangbusters returns in the first few months after their debut, it likely means the offer price was too low, leaving the founders’ money on the table. This is a big reason why average IPO returns in the first few months and even years are normally weak, according to data from University of Florida Professor Jay Ritter, aka America’s IPO Data Maestro.[x] The majority of 2021 US IPOs’ reportedly being underwater seems entirely consistent with this history, in our view.
In our view, IPO activity is most telling for what it shows about investor sentiment and stock supply. To the former, we think this year’s bust is another indication that early-2021’s optimism has largely worn off. As the year dawned, IPO and SPAC cheer rang throughout the financial publications we monitor. Many commentators were watching for froth that could eventually permeate the entire market, bringing the euphoria that our research shows often accompanies bull markets’ ends. Now, it looks like those once-frothy corners have self-deflated without infecting the broad market, a sign stocks overall likely have plenty of the proverbial wall of worry to climb. On the supply front, a parallel boom in stock buybacks (in which companies purchase shares of their own stock, taking them off the market) has helped keep total stock supply from running away. Net issuance is still high year to date, according to our research, but it hasn’t yet made up the steep deficit since 2009—in other words, there remains a net stock supply decrease since the 2009 – 2020 bull market began. That suggests to us that even with the recent increase, we don’t yet have the supply glut that would signal an approaching market peak.
[i] “Initial public offerings” are formerly private companies that list and sell shares to investors on public equity markets.
[ii] “IPOs Had a Record 2021. Now They Are Selling Off Like Crazy.” Corrie Driebusch and Peter Santilli, The Wall Street Journal, 29/12/2021. Accessed via The New York Ledger.
[iv] Source: Refinitiv, as of 29/12/2021. IPOX SPAC Index returns, 31/12/2020 – 28/12/2021 and 17/2/2021 – 28/12/2021. Presented in US dollars. Currency fluctuations between the dollar and pound may result in higher or lower investment returns.
[v] Source: FactSet, as of 29/12/2021. Statement based on MSCI World Index Growth returns with net dividends in GBP.
[vi] Ibid. Statement based on MSCI World Growth and Value Index returns with net dividends in GBP, 16/3/2021 – 30/9/2021.
[vii] Source: FactSet, as of 29/12/2021. MSCI World Small Cap Growth and Large Cap Growth Index returns with net dividends, 23/3/2020 – 31/12/2021.
[viii] Ibid. MSCI World Index return with net dividends in GBP, 16/3/2020 – 31/12/2020.
[ix] Ibid. MSCI World, Small Cap and Large Cap Growth Index returns with net dividends, 31/12/2020 – 28/12/2021.
[x] Not his actual title, but we would confer it if we had the power to do so. You may find Professor Ritter’s data on his website at the University of Florida’s Warrington College of Business. Our statement refers to “Initial Public Offerings: Updated Statistics” for the years 1980 – 2021.
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