History Says This Is What Happens to Mega-IPO Stocks in Their First 12 Months

The history of initial public offerings is often volatile and not necessarily positive. The transition from a private entity to a publicly traded company brings new information but also emotions that are rarely seen after the initial period. Such conditions can bring to mind Warren Buffett's saying about IPOs, and they were not positive.

The performance of the June IPO of Space Exploration Technologies and the debut of SK Hynix in the U.S. in July may speak to some of the challenges of this process, even when they involve investing in the most sought-after stocks.

Knowing that, investors should probably take the retired CEO of Berkshire Hathaway's words to heart and proceed with such events cautiously. Here's why.

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A lesson from Buffett

Buffett said a lot about IPOs. However, this short quote probably explains that view most succinctly: "An IPO is like a negotiated transaction -- the seller chooses when to come public -- and it's unlikely to be a time that's favorable to you."

This makes sense upon reflection. The primary purpose of going public is to raise money. Typically, companies can raise the most money during bull markets.

This means they almost always happen when stock prices are at their highest. Since every past bull market in history gave way to a bear market, it should not surprise investors that prices were often not higher one year later.

Admittedly, Buffett successor as Berkshire CEO, Greg Abel, piled $930 million into one such stock recently (Bending Spoons), so Buffett's philosophy may not reflect Berkshire Hathaway's investing approach today. Nonetheless, Buffett targeted what he called "excellent companies at a fair price," and such "fair prices" are less likely in such an environment.

What to expect from an IPO

IPO periods are also somewhat emotion-driven. Since investors may have long awaited a stock's debut, they often buy at the earliest possible moment regardless of the price.

However, according to a Nasdaq study, these investors also consider growth rates. Initial valuations will tend to be high when revenue rises rapidly.

Such metrics can also increase volatility. Over the course of that first year, the sentiment around the stock tends to shift from hype to the fundamentals. Investors do not necessarily expect immediate profitability. Still, if strong sales growth does not back the positive sentiment, the odds are high that the stock will underperform the market over the next year.

Another factor is lockup periods. Companies often bar insiders from trading a stock after an IPO. These time frames vary in length but often last 180 days. Once those periods expire, insiders often choose to sell. Although expirations do not technically increase outstanding shares, they add selling pressure that tends to push prices downward.

Investors should also not expect help from the major indexes. Although a company may meet the requirements to join the S&P 500 (SNPINDEX: ^GSPC) or another index, it typically must complete a so-called "seasoning period." This means the stock is expected to have a significant trading history or meet profitability requirements, so it will likely not join an index until well after its IPO.

Investing in mega-IPOs in the first year

When it comes to mega-IPOs, investors should probably defer to Buffett's advice and proceed cautiously, if at all.

Investors should never forget that companies go public primarily as a funding mechanism. That makes it likely they will launch an IPO in the middle of a bull market. That fact alone can cause IPO stocks to fall when the inevitable bear market occurs.

Moreover, the prospect of rapid revenue increases can amplify hype and influence valuations in such stocks. If a company cannot sustain the rapid growth needed to achieve those targets, hype may give way to fundamentals, and investors may punish that IPO stock.

That selling also tends to accelerate when lockup periods expire, and more insiders decide to sell. That suggests a higher risk than reward when investing in IPO stocks.

Will Healy has positions in Berkshire Hathaway. The Motley Fool has positions in and recommends Berkshire Hathaway. The Motley Fool recommends Nasdaq. The Motley Fool has a disclosure policy.