Investors love growth, and no investment says “growth,” quite like the stocks of initial public offering (IPO) companies. Typically, IPOs are fast-growing firms with promises of vast runways for future growth. Most don’t make a profit, but investors and founders bet that profitability will come when the IPOs investments begin to bear fruit. Many IPOs trade at what conservative investors would deem obscene valuations, and for much of 2021, they would have looked at the IPO market with horror. For much of the year, 2021 was a record-breaking year, with IPOs soaring after entering the public markets and setting a run trading above their IPO price. Yet, as the Wall Street Journal reports, those glory days seem so distant now, after a selloff in high-growth stocks that have left IPOs trading below their IPO prices.
2021 was a blockbuster year for IPOs, with IPOs raising capital at all-time highs, with startup founders and early investors eager to take advantage of the market’s excessive valuation. However, the market’s optimism was not just about IPOs, but part of a broader desire by the market to seek out high-growth firms.
For those investors who paid attention, the selloff in high-growth stocks was foreseeable. Insiders in established businesses, such as Satya Nadella of Microsoft, Elon Musk of Tesla, and others, had already started to sell shares in their own companies. Moreover, the phenomenon was so widespread that it is clear that insiders realized that their businesses were trading at extreme valuations.
Yet, the party had to stop. Whereas the first eight months of the year saw the IPO market set a blistering pace, such that by November, when market volatility had already started to hit the markets, the average IPO was up 12% for the year, the last few weeks of the year have been awful, with IPOs down 9% compared to their IPO prices.
The rush to list was also a reflection that founders and entrepreneurs sensed that the moment had arrived to cash in. There are two contradictory reasons why companies go public: the first is that they feel that the market is ready to give them the very best possible price. Remember, going public means that the company is selling shares to the public, and every rational CEO wants to do this when they believe that the market will offer them the best price and best means, highest. The second reason companies go public is that they think that the economic opportunities they have are so large that they need to enter the market to raise capital to take advantage of them. The two motives can co-exist, and this has to be remembered. A surge in IPOs can signify that founders believe that investors are ready to give them the highest possible price.
The selloff was triggered by investor fears that the Fed would hike interest rates in 2022. Speculation turned into confirmation when Fed chairman, Jerome Powell, announced that the Fed would hike rates three times in 2021. An interest rate hike would affect business valuations, making once cheap but risky assets seem that much more expensive. The result is that two-thirds of IPOs that went public in 2021 will end the year below their IPO price, a complete reversal of the trend in 2020.
It is also a reversal of the situation in March, when South Korean eCommerce firm, Coupang, went public. At that time, over two-thirds of IPOs were trading above their IPO price. It seemed like a time when fundamentals didn’t matter, and you just had to buy an IPO to make a massive return.
Well, fundamentals do matter, and as David Trainer of New Constructs pointed out, many IPOs this year had terrible fundamentals. It was only with the fear of interest rate hikes that investors started to realize that they were holding a lot of businesses whose economic models were broken.
Investors were willing to ignore the bad economics of these businesses because it was and still is an era of historically low-interest rates, with some economists speculating that this is part of an eight centuries-long, suprasecular trend. Even after a likely interest rate hike in 2022, interest rates will still be meager unless inflation concerns force a much more dramatic hike.
Once investors process that, valuations are likely to shoot right back up, and once again, investors will ignore market fundamentals. It will take something much more significant to trigger a more long-lasting change to investor behavior and an era of greater investor prudence. One source of potential long-term change is the global supply chain disruption, which has affected everything from semiconductors to lumber prices, making it an absolute miracle if you can get a new server or have dried firewood delivered. If the global supply chain disruption sticks, then inflation sticks, and suddenly fundamentals matter for more than just a few months.