It was the best of times, it was the worst of times … for initial public offerings (IPOs) in 2021, that is. 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) topping $300 billion year to date—almost double 2020’s previous record, according to a Wall Street Journal report.[i] Yet according to the Journal’s analysis, banner deals haven’t brought banner returns: Among the 384 companies going public the traditional way this year, 255 are now trading below their offer price.[ii] An index tracking SPACs, meanwhile, is down -15.3% year to date and -33.1% from its mid-February peak.[iii] In a refreshing turn, we aren’t seeing many folks call this a repeat of 2000’s dot-com crash. But there is a school of thought arguing rising interest rates are the main culprit, allegedly making it less attractive to pay a premium for growth 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 stocks’ overall returns, which are pretty darned good. Growth is beating value by a smidge year to date—and by a mile since mid-May, when value’s brief countertrend rally (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 many fresh non-SPAC IPOs fall into, soared during the first phase of the post-lockdown rally that began in March 2020, rising 101.7% from 3/23/2020 through that year’s end while large-cap growth delivered “only” 79.4%.[iv] Both outperformed global stocks’ 70.0% 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.[v]
In 2021, small-cap growth is up just 9.7% year to date, badly trailing global stocks’ 22.1%, while large-cap growth is outperforming at 23.9%.[vi]
We see a simple reason for this: Stocks are behaving as they normally do late in a cycle, when investors increasingly seek the highest-quality companies—a fact the high rate of companies going public this year supports. 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 large growth companies also 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. Those have come particularly in handy lately as companies weathered higher costs and supply chain pressures. The largest growth companies have much more of a buffer to handle this. They also have the ability to self-finance investment and future growth, which becomes important as the yield curve flattens—which is likely next year, courtesy of a Fed rate hike or two. New IPOs may grow into high-quality large companies one day, but for now, many are riding more on hope than strong cash flows, likely making them less attractive.
Another factor bringing IPOs’ disappointing returns is the alternate interpretation of their acronym: It’s Probably Overpriced. When a company goes public, the goals are twofold: To raise money and to give early investors the chance to cash out. Both goals incentivize 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 means the offer price was too low, leaving 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 the IPO Data Maestro.[vii] The majority of 2021 IPOs’ being underwater seems entirely consistent with this history, in our view.
In our view, IPO activity is most telling for what it shows about sentiment and stock supply. To the former, 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 everywhere, putting the world on watch for froth that could eventually permeate the entire market, bringing the euphoria that 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 wall of worry to climb. On the supply front, a parallel boom in stock buybacks has helped keep total stock supply from running away. Net issuance is still high year to date, but it hasn’t yet made up the steep deficit since 2009—in other words, we still have 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] “IPOs Had a Record 2021. Now They Are Selling Off Like Crazy.” Corrie Driebusch and Peter Santilli, The Wall Street Journal, 12/29/2021.
[iii] Source: Refinitiv, as of 12/29/2021. IPOX SPAC Index returns, 12/31/2020 – 12/28/2021 and 2/17/2021 – 12/28/2021.
[iv] Source: FactSet, as of 12/29/2021. MSCI World Small Cap Growth and Large Cap Growth Index returns with net dividends, 3/23/2020 – 12/31/2021.
[v] Ibid. MSCI World Index return with net dividends, 3/23/2020 – 12/31/2020.
[vi] Ibid. MSCI World, Small Cap and Large Cap Growth Index returns with net dividends, 12/31/2020 – 12/28/2021.
[vii] Not his actual title, but we would confer it if we had the power to do so.
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