Should you buy that IPO? Here’s why hot startups lose their heat by the time you can buy their stock

ByJames Dennin

Something seemingly unnerving is happening in the American stock market.

Back in 1997, there were more than 9,000 publicly listed U.S. stocks — meaning lots of options for investors with a little cash and big ambitions.

As of June 2016, that number had dropped below 6,000, according to University of Chicago data reported by the Wall Street Journal. That's about as many public companies as there were in the early '80s — when the economy was half its current size.

Indeed, last year was the slowest year for initial public offerings — aka when you, non-Warren Buffett normal, can buy a company's stock for the first time — since 2003, according to DealLogic.

But what does it mean if the number of public companies, as the Journal puts it, is "shrinking before our eyes"? Do fewer IPOs really mean the "best investing prospects" are moving "out of the reach of ordinary Americans"?

There's definitely some truth there, yet it might not be for the reason you think.

A declining number of "hot" startups to invest in on IPO day is not so much the problem itself as a signal of why — among other reasons — making big bucks as a "little guy" investor isn't something you can just take for granted.

How so?

"I would answer the question by thinking back to the Dodd Frank bill," said Larry Swedroe, director of research at Buckingham Strategic Wealth. "The costs of being a public company has gone way up. And so what has happened really isn't that IPOs are disappearing, what's happening is that you have to be much bigger."

What Swedroe means is small new companies aren't going straight to IPO as much anymore: They are getting beefed up through growth and private investors first. (Those guys tend to be rich enough not to have to wait for the IPO — though that's starting to change, too.)

So by the time you can actually buy shares in that under-the-radar company that seems like it's going public any day now?

Much of the value inherent in being the-still-undervalued-next-great-thing has already been captured by others.

"What's changed is that founders have wanted to exert more control over their companies, and because of the private markets they have that advantage," said former investment banker and Wharton business school senior fellow David Erickson. "Mark Zuckerberg went public at an $80 billion market cap. It would have been great to invest in Facebook when it was only worth $1 billion."

Swedroe argues that that's an argument for Joe Schmoe-types to actually just steer clear of freshly minted stocks: "The people who cash in on IPOs are the friends of the Goldman Sachs of the world," Swedroe said. "People shouldn't be buying this stuff anyway."

Still, Erickson argues, IPO-buyers have plenty of room to cash in — assuming they are smart (or lucky) enough to pick the next Facebook: "$80 billion to $300 billion is a nice appreciation too," Erickson said. "There's still opportunity."


Either way, the shift away from the feast of choices investors got in, say, the 1990s — well, it might be a good change.

"We're kind of back where we used to be," said professor Donna Hitscherich, director of Columbia Business School's private equity program. "Your readers are probably too young to remember, but there was a time when you actually had to have earnings records in order to go public."

Which is all to say that there's really nothing wrong with unprofitable companies like Uber staying private for longer.

And despite the market including fewer and fewer new companies, stock prices have still climbed over the same period, as you can see in the below tweet from TopdownCharts.

No matter how much the financial press hypes IPOs of hot (and controversial) companies like Uber and Snapchat, Swedroe notes that investing in an IPO is not unlike having a go at the Roulette or Blackjack table.

"They are buying lottery tickets when they're doing it, and while that may be okay with a dollar if you value the entertainment," Swedroe said, "I wouldn't take my retirement to the racetrack."

So — if you want the growth potential of stocks, as you should as a millennial — what should you be buying instead?

Look for investments that minimize risk, like cheap, broadly diversified index funds or exchange traded funds.

These let you capture the stock market's growth without assuming nearly as much risk as individual stocks.

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