With Arm and Instacart hailing blockbuster listings this month, it could be easy for investors to get caught up in the excitement. But Goldman Sachs has another approach: it has identified two key measures that can help predict how successful an IPO may be in the long term, irrespective of whether the stocks have an early bubble or bust.
To identify these factors Goldman’s Chief U.S. Equity Strategist, David Kostin, and a team of analysts sifted through 5,000 IPOs from the past 25 years.
Their conclusion is that the U.S. IPO market has been in a two-year “drought” but that it is finally bouncing back in “dramatic fashion” — returning to normal levels seen before the volatility of the pandemic.
The note seen by Coins2Day shows that while there were more than 400 IPOs in 2020 to 2021, just 32 U.S. Firms floated in the past 21 months.
Yet the pre-pandemic buzz didn’t necessarily lead to a return for investors, Kostin points out: “The 2020-21 wave of IPOs had abysmal performance relative to history. The median IPO completed during 2020-21 lagged the Russell 3000 by 48 pp in the first 12 months following its IPO, with just 18% managing to outperform.”
Companies that floated during this time weren’t necessarily bad investments, Kostin points out, saying that many businesses were enticed out by low interest rates which promptly leaped in 2022. Meanwhile, equity prices fell and so “the window slammed shut.”
But as the sector ramps up again, the age-old rule of quality of IPO, not quantity, should be observed by investors looking for long-term gains.
Metrics to look out for
The two headline flotations of 2023 have certainly got off to a buzzy start.
Chip engineer Arm saw its share price jump nearly 25% in one day after it floated on the Nasdaq, after selling shares at $51 — the upper end of its expected range.
This noise could have been predicted to some extent, Kostin writes, as stocks that are priced above their expected range usually rise by 38% on their first day of trading.
“This effect was even more pronounced for deals completed since 2020,” he added. “IPOs priced above the range typically jumped by 43% on their first day of trading. In contrast, deals priced below the range were essentially flat on day one (+1%).”
Meanwhile, grocery delivery company Instacart saw shares pop 40% to open at $42 before the price sank in the days following.
While not all investors are convinced by the offerings—ARK CEO Cathie Wood, for example, said she steered clear of Arm because of its focus on AI—Kostin says floated companies have some time to prove themselves.
His two signals to look for as an indication of a successful IPO are: “Greater than 40% annualized sales growth in their second and third years after flotation and positive net income by their eighth quarterly earnings report.
“Two-thirds of IPOs with these characteristics outperformed the Russell 3000 in their first three years with the typical company outperforming by 22 pp.”
Eye on profitability
Although the Goldman analyst acknowledges the lackluster performance of 2020-21 shares are partially down to economic factors, he also points out they were lacking in sales growth when compared to other periods of high activity.
In the pandemic cohort, Kostin writes, sales growth was slower — the businesses posted an average growth of 9% by their third year as a public company compared to 14% growth in the 2001 to 2019 period.
On top of that pandemic IPOs were also less profitable, he adds: “Just 52% of this class was profitable by its third full year as a public company, well below the 71% of 2001-2019 IPOs that turned a profit by year three.”
This is a further metric to keep an eye on, Kostin explains: “We expect profitability will be especially important for upcoming IPOs. With capital markets closed for nearly two years, unprofitable companies have been forced to fund operations by spending cash balances.
“This experience has driven investors to prefer stocks with high levels of current profitability.”