The Secret to Investing in IPOs Is Timing

The close of the summer season has typically stoked the initial public offering market and, with it, a growing interest from investors.

More than 100 companies have debuted on the stock market this year, an increase of almost 35 percent compared to the number of firms "going public" in the U.S during the same time period last year. Additionally, the number of companies registering for IPOs in the U.S. has surged, promising an attractive flow of companies to hit the stock market over the next year.

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After a somewhat dismal IPO market in 2016, this uptick presents a unique opportunity for investors to capitalize on these newly-listed stocks. But when it comes to such investments, timing is everything.

Translating the success. The flourishing future of the IPO market is buoyed by the increasing number of private companies that have attained a level of success that can translate from the private to the public market. For example, companies such as fast-growing streaming television producer Roku (Nasdaq: ROKU) recently debuted on the stock market, and online digital music provider Spotify is expected to go public in the next few months.

Other businesses, like database startup MongoDB and BP pipeline (North America), a spinoff of U.S. energy assets of the global energy behemoth BP ( BP), are also in the IPO pipeline. And, given strong stock markets and a potential first mover advantage, we also expect IPOs from unicorns -- those startups valued at over $1 billion -- to increase, including on-demand ride sharing platform operators Uber Technologies and Lyft.

Opportunities abound, but there are risks. This bountiful pipeline of IPOs has created a unique trading opportunity for both investors looking to trade on a short-term basis, or buy and hold a newly listed issue for multiple years. As such, interest in investing in IPOs has been increasing among both retail and institutional investors over the past years.

According to IPOX Schuster, IPOs surged by an average of 14.01 percent on their first trading day (based on the difference between the final offering price and the closing price, according to data going back to 2002), with only less than 20 percent of deals closing the first day in negative territory.

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As evident over the last several months, some highly-publicized IPOs debuted with less-than-stellar results. Identifying the most promising investments within the IPO market, thus, can prove somewhat challenging, given the difficulty of valuing an IPO and respective uncertainty about the actual risk of a deal at the date of debut. During the first few months of trading in aggregate, these stocks are typically dominated by institutional constraints and a lack of fundamental information.

While such companies have performed well on average, the median IPO has lagged, however, with more than 57 percent of deals trading significantly below first close price after four years. Examples of such performance include Frank's International NV ( FI), Groupon ( GRPN) and (at almost four years) Twitter ( TWTR).

Moreover, IPO performance has also been sensitive to firm characteristics such as deal size or sector, as well as well as at what stage the respective company trades in the post-IPO window.

Look to the secondary market. Accessing IPOs on the primary market is difficult and may not be possible for individual investors. However, the secondary market still presents a meaningful opportunity for investors to access the potential excess returns that come with investing in IPOs. For example, the IPOX 100 U.S. index, a proxy for the secondary market performance of the largest 100 IPOs and spinoffs in the U.S., has more than doubled the performance of the Standard & Poor's 500 index since its inception in August 2004.

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Additionally, a company trading in the post-IPO window, defined as the first few years of trading in the market, has also been more likely to be involved in corporate mergers and acquisitions when compared to another incumbent firm. This has the opportunity to boost the stock performance, even substantially.

Some examples of significantly performing U.S. stocks this year include biotech Kite Pharma ( KITE), which had its IPO in 2014, life science equipment maker VWR ( VWR), which also debuted in 2014, and Ohio-based sandwich maker AdvancePierre Foods Holdings, which had an IPO in 2016 and then was bought by Tyson Foods ( TSN).

These impressive results underline why investing in IPOs, even on the secondary market, can be a winning strategy.

David S. Miller is the co-founder of Catalyst Mutual Funds, where he serves as senior portfolio manager and CIO overseeing several of Catalyst's investment funds. Prior to joining Catalyst, he was founder and editor of the Investment Catalyst Newsletter. He also worked at UBS as an equities derivatives trader. Miller is a graduate from the University of Pennsylvania's Wharton School of Business, where he received a bachelor's degree in economics. He holds an MBA in finance from the University of Michigan.