Shopify Inc. (TSX:SH)(NYSE:SHOP) had its initial public offering last week. In the first two days of trading, it traded between $30 and $38 (26% difference), and now sits around $35.
Another big one at the time was Facebook Inc. In the first few months of trading in 2012, Facebook went from $40 to $20, a 50% drop. At the time, headlines of Facebook being overpriced could be seen everywhere.
Of course, one could argue that Facebook is worth $80 on the market today, double the original price. Imagine if some investors bought at $40 and couldn’t hold on when it dropped 50% and sold. That’s a classic example of capital destruction that no investor wants to see in their portfolio!
Yet others could have bought around $20, making four times their investments if they sold today. However, this is all in hindsight.
First, let’s try and understand why companies offer slices of themselves to the public.
Why do companies offer shares on the market?
Companies sell their shares to the public to raise money to grow the company, for example, by investing in new projects and hiring more talent. As an investor, you get a slice of the company, but at the same time, you take on the risk of the company as well.
The other way companies can gain financing is by offering debt, such as corporate bonds. In doing so, they pay out interests. Bondholders don’t take on the risks of the company. They simply lend money to the company and in return, get paid interest. However, companies could go bankrupt.
In such a case though, the company would sell its assets, and the proceeds would go to bondholders first before investors. So, there’s a high chance investors will get nothing back if a company defaults.
Reason 1: Higher volatility
Many investors jump into new stocks, hoping to gain a quick buck. These are traders who see an opportunity to gain volume in a stock and might even exit within the day after making, say, a 10% profit.
This causes higher than normal volatility for a stock that could result in unintentional, emotional buying or selling.
Reason 2: No historical data implying higher risk
There is enough uncertainty in the market and the future already. New, publicly traded companies are even more unpredictable.
Investors simply don’t know what kind of multiple the market will assign the new company because there is no historical trading information.
Reason 3: No stable cash flow. No dividends.
The company is still in its growing phase, and it’s most likely aggressively growing. That means it’s reinvesting all its earnings into its business on top of putting in money raised from the market and/or debt offerings. These investments aren’t guaranteed to increase the company’s value. That is, the company could fail in some of its investments.
In fact, in early years, it’s common for companies to have negative earnings. This means that there will be no dividends for shareholders, unlike established companies that earn stable cash flows, which reliably do.
In conclusion
I’m not saying that investors can’t make money from newly publicly traded companies. However, investors should understand that the expectations of returns for these companies are very different from established companies that pay a consistent dividend.
Because I believe investors take on more risk by investing in new companies, new investors with little experience in the market should avoid buying new companies.
Understand that people buying these new companies aren’t looking for dividends, but are looking for aggressive growth that may or may not succeed.
