IPO Data Exposes the Stock Market Overvaluation in 2022...

So you might have heard the term IPO at some point over the past year, and that's because there's been a lot of IPOs happening. The acronym stands for Initial Public Offering, and this is the process where a private company becomes a public company. So private companies, they still have investors that buy and sell stakes in that business, but the shares aren't freely traded on a public exchange. When a company goes public, they create a big new packet of shares for investors to buy, and then the shares of that company start trading on a public market.

So why does this happen? Well, the main point of an IPO from a company's point of view is to raise money from investors like you and me. If they, perhaps, want to acquire another company, or they have grand plans to open new stores, they might find the money they need through the IPO process, through selling new shares to the public. Now, IPOs are nothing new, but what's been a little crazy is the sheer number of IPOs that are happening right now, and this is usually a bit of a signal that the stock market itself is very overvalued.

So in this video, we're going to talk about just how big this IPO boom is. Then we're going to discuss why it's a sign that the markets are actually pretty hot.

[Music]

Well, no doubt 2021 was a big year for many reasons, but definitely in the IPO market. We had big names such as Rivian, Robinhood, Coinbase, Roblox, Bumble, Udemy, and more all go public. In fact, in 2021, we saw a total of 2,388 IPOs around the world, raising 453.3 billion US dollars in proceeds, as a 64% and a 67% respective increase year-over-year. Quote, in the U.S., a record 388 operating companies debuted in 2021, raising 30.2 billion in the process, as of December 7, according to data from Renaissance Capital.

For the sake of comparison, more companies have gone public in the U.S. in 2021 than in 2019 and 2020 combined. Business is booming, you might say, but actually a high number of IPOs really just means the stock market is right near its maximum. This has been true throughout history. Have a look at this chart that's going back through the years. In the last few years, we have seen hundreds and hundreds of IPOs in the U.S. Right before the global financial crisis, there were heaps of IPOs. Right before the tech bubble burst, heaps of IPOs. Lots of companies seemed to go public right at the hottest times in the market.

And then look, when the stock market crashes, nobody is looking to IPO at all. There were just 21 IPOs in 2008 after the GFC and just 80 in 2001 right after the tech bubble burst. But why? Why does the number of IPOs in a year actually seem to line up with stock market booms and busts? Well, it's because overvalued stock market conditions are actually favorable for companies trying to IPO, whereas recession conditions are very unfavorable.

So let's have a look at this from the company's perspective. Say you started a company, it did pretty well, and now you're considering going public to sell a chunk of your business. You're going to create and sell some new shares to the public to raise some money for, say, a few new stores. Well, in this scenario, you want the stock market to be really, really overvalued because if everyone across the public markets is paying through their teeth for ownership stakes in public companies, even if they're speculative, unprofitable, debt-riddled, etc., that means you'll likely fetch a really high share price on IPO day.

If there's a lot of money floating around the system from investors, it's going to be easier for an average company to sell their shares. It's going to be easier for them to fetch a good share price. Now, this means one of two things: one, if you have a set amount of cash you'd like to raise from the IPO process, it means you have to sell less shares, so less of your business, to raise that money; or if you just wanted to sell a certain number of shares on IPO day, then it means you'll likely rake in more cash than you would have originally intended by IPOing.

Now, awesome! Boy, is it fun to go public in overvalued market conditions if you're the business owner. And naturally, on the flip side, if we are in, say, a high interest rate environment, there isn't a huge amount of money floating around from investors. You know the economy isn't growing, we're in a recession, and people really aren't optimistic about the future of business. Well, it's going to be very hard to come along and convince new investors that they should buy some shares of your new technology company.

Hence, we see almost no IPOs right after the tech bubble burst. We see no activity after the GFC. So that's the reason why we see a lot of IPOs when the market is flying, and we see almost no IPOs when the market has crashed. The market is hot, IPOs are easy money for the company, so they will all try and get in at once to raise that cash because investors are just going to find any old place to park their money, even if they overpay and settle for lower returns.

Rivian is a recent example of this. This is a company that had barely delivered a single vehicle when they IPO'd, yet they reached a market cap of over a hundred billion dollars on day one of trading. They raised 12 billion dollars from their IPO process—12 billion dollars from investors, no revenue, just a series of future promises. So it's an interesting dynamic, but knowing how this system works is also handy for us investors more broadly because we can use the IPO markets to show us a hint at the current state of the market.

And have a look at some of the average first-day returns of new IPOs. In 2021, the average first-day return was 32%. In 2020, it was 41.6%. In 2019, it was 23%. In 2000, it was 56%. In 1999, it was 71%. These returns are insane! They defy all logic. No IPO should jump that amount on average in the first day. It just sounds like euphoric, optimistic speculation.

And then have a look at the average first-day returns in 2001: just 14% after the tech bubble burst. Then the average first-day return in 2008 was just 5.7%. So we, as investors, can look at this data to see whereabouts we are in that cycle, and at the moment it seems we are right at the end of the cycle. You know, IPOs are the thing! More IPOs in 2021 than in 2020 and 2019 combined. Average one-day return is an astonishing 32%. More and more businesses want to go public in these conditions, and investors are throwing money at literally anything right now.

These facts that we can see in the IPO data definitely suggest that the market is getting a little bit silly right now. But there's another way to look at this scenario. You know, surely the data suggests that right now we should just be buying IPOs. 32% returns in one day sounds amazing and seems like it would be very profitable. No? Why don't we just do that? Well, it might be profitable for a bit, but unfortunately, with this approach, sooner or later you're going to get caught out trying to buy into the hype. Buy into the speculation, buy into the number 32, and the IPO won't go up that easy—30%. In fact, it might go down 30%. You just don't know when the IPO honeymoon will come to an end.

And in fact, there is some data that shows that it might already be ending. This Fortune article from the 14th of December shows that about half of the stocks involved in the 100 largest U.S. initial public offerings in 2021 are actually trading below their offer prices currently. They note that, quote, "the Renaissance IPO exchange-traded fund, which currently tracks a basket of 106 stocks that have gone public in recent years, was down 11.5% on the year as of Friday morning, but just three weeks ago it was up 7% on the year."

So just in the past few months, we've started to see IPOs cool off a little bit, and this is always the difficulty in trying to make money speculatively, you know, just by buying all of the hot new IPOs. And personally, because they are so speculative, I never buy any IPOs. You know, as Warren says, rule number one is to ensure you don't lose money. And when you start playing roulette with big new IPOs, you're definitely violating that investing law.

And unfortunately, when it comes to IPOs, we also have a severe lack of historical financial data that shows you how the company has performed over time. You know, how have they grown? How have they managed debt? How has the management team held up in the ROIC department? These are all critical pillars to look at as an investor to make an informed investment. But when it comes to a new business that recently IPO'd, you might have one or two years of financial data, tops. And for me, anyway, that is simply too little information to be able to confidently predict your future returns by owning shares in that business.

So at the end of the day, it's a bit of a gamble, and that's not really what I'm about with my investing. I like bets with much more certainty. But overall, that's the tale of our current IPO boom, and hopefully that shows that, you know, as long as the markets stay as they are, we'll likely see many more IPOs again this year. But you know, with 2021 having more IPOs than the previous two years combined, it certainly seems like CEOs are trying to get in now before these market conditions end.

So overall, guys, that's the tale of the IPO boom. I hope you learned something. I hope you found this video enjoyable. Leave a like on it if you did, subscribe to the channel if you're new around here, and, uh, yeah, jump on board for 2022. Happy New Year to everybody! I hope you had a good Christmas and year break; I certainly did. I'm back at it now, about to move into the new office, so I'm excited about that. But guys, that'll do us for this video.

Um, thanks very much for watching! If you're interested in how I go about my investing, check out Profit Full, links down in the description below. You can check out New Money Patreon, and thanks very much to the Patreon producers for sponsoring, for helping with the content, helping finance the content. I certainly appreciate it, and that's just about it for today, guys. Thank you very much for watching, and I'll see you guys in the next video.