Should You Chase the Next Big IPO? – Using SpaceX to understand IPO access, pricing, and expected returns.
Marcus Schafer (00:17)
Welcome to episode 35 of the decision dividend with Pat Collins and me, Marcus Schafer of Greenspring Advisors. This is where Logic meets life and investing. Pat, today we are going to be talking about all of these hot IPOs. Most notably, it came out recently that SpaceX is planning to go public. So, what does that mean for investors, both of diversified strategies and also investors who might be trying to get access specifically to SpaceX?
Decision vs. Outcome (1) – How base rates and the outside view can help investors evaluate SpaceX, OpenAI, Anthropic, and the next big IPO.
Pat Collins (00:46)
It reminds me of the the days when I started in this business during the the internet boom. ⁓ but I think this really dovetails nicely to the episode. If any of our ⁓ audience was listening last week or last the last episode, we talked a lot about decisions and outcomes. And this is one that’s kind of really on display, in my opinion, is a great example of thinking about what is a good decision? Should I participate in this somehow? And then what’s the outcome? And I think we’re going to talk a lot about.
the decision today, which is what are all the things that should go into making a decision on whether you should participate in this? What is the probabilities? What are the, what’s history tell us? What perspective do we have on that? We don’t know what the outcome’s going to be at this point. So I think that’s going to be to be determined. But I think one of the takeaways from last week that I thought you really put well, the outcome tends to influence how we perceive our decisions. And so depending on what SpaceX does and depending on whether you participate in that or not,
It’s probably gonna be heavily influence whether you think you made a good decision or not. We’re gonna give you hopefully the data in this episode to hopefully make a good decision. And hopefully you can d divorce that from the outcome that you end up having.
Marcus Schafer (01:59)
Yeah. Two of the five tools we talked about last week will be prominently displayed here. One, base rates, right? So what is the average expectation for IPOs? And is something like SpaceX and OpenAI and anthropic, are those really average scenarios? So we’ll kind of maybe talk about that a little bit. And then two is that outside inside view, which is hey, if you view it from somebody else’s perspective, what what do you think about this situation? But
I mean, I think one of the one of the nuances that makes this jump out is just the fact that there is so much hype around those three companies in particular. The valuations that have been quoted, the pricing ⁓ in terms of the market cap and how big these companies could be. So I think that’s maybe like one of the unique things where IPOs happen quite honestly a lot. Most of them are small. And so nobody really kind of sees them unless it’s something.
that you have particular expertise in. But here I think everybody in in America is kind of reading these headlines and across the globe.
SpaceX at a Mega-Cap Valuation – Why a remarkable business can still require extraordinary growth to justify an extraordinary price.
Pat Collins (03:04)
Yeah, I thought it’d be fun to kind of just look at what the expectation is for this this most recent one with SpaceX. You know, they are estimating a market capitalization of 1.75 trillion. that number is really hard to for many people to comprehend, but just to put it in perspective, ⁓ if that turns to be the it turns out to be the case that it actually goes public and that’s what the valuation ends up being, that would put it at the eighth largest company in the world.
⁓ so it would be a mega cap company, basically. A few things just to mention on that. ⁓ first is when you look at its revenue or anticipated revenue, which is a little over 18 billion in revenue, which is a lot of money, but it puts it well north of the 500th largest company in the US. I tried to look for some comparables of what companies kind of do the same amount of sales as SpaceX is doing right now. Here’s three examples.
Illinois Toolworks, Best Buy, and TJ Maxx Ross stores. So, you know, you would never think of any of those companies as being one of the top 10 largest companies in the world. So ⁓ obviously a lot of hype around SpaceX, a lot of hype around the future potential of it. ⁓ it is trading at a hundred, or if it if it goes public at that price, it’s trading at a hundred times revenue.
⁓ and that is a staggering valuation ⁓ to pay. So obviously, you know, that would mean if it maintained its current revenue count and it had no expenses, it would take about a hundred years to pay you back, basically, in the form of dividends or earnings or whatnot. And so clearly what the market is probably saying here is we expect
There’d be lots of growth out of this company that is not gonna be eighteen point seven billion dollars for long, that it is going to grow substantially over the years. And that’s kind of the bet that you’re making.
Limited Float, Lockups, and Hype (2, 3) – How limited supply, insider lockups, and investor excitement can shape the early IPO experience.
Marcus Schafer (05:03)
One note, which we’ll kind of get into maybe a little bit when we talk about how diversified investors might might get exposure, but that $1.75 trillion market cap, that’s kind of if they were to list the whole thing. What they’re really talking about is a lower free float listing. That’s going to have a lot of implications, but that’s actually going to, you know, what amount of shares can you actually purchase and can be sold on secondary markets? That’s a much smaller.
Number where that might be call it five percent of that. And then there’s all these different types of things like insider lockups that are going to come into play that really reduce a lot of the actual volume that’s available for trade. So what are the implications of that? Volatility is one of the implications of that. But yeah, SpaceX, if you look historically looking, now one note on this is to your point.
The numbers that we’re looking at, those are past profitability type metrics. The research does show that past profitability is a really good predictor of future profitability. And it actually predicts future profitability pretty far out. But when you see these really, really high expectations, just know it’s going to be really tough to ⁓ meet those expectations.
Pat Collins (06:25)
Yeah, yeah, absolutely. I think it’s is it’s probably maybe taking a little bit of a step back from SpaceX, just talking about the broader landscape. there’s just been an overall trend over the last 20-ish years or so of less companies going public than probably, you know, ⁓ pre-2000, let’s just say. And there lots of reasons for that. There’s pretty significant regulations if you’re a public company. There’s a lot of shareholder protections, ICC requirements for
and it’s costly for companies to do that. there’s a lot of public disclosures that you have to make. So a lot of companies have decided to stay private longer or stay private indefinitely. And I think the other thing that’s come up over the over the last 20 years is just the rise of private equity. And so there are other pools of capital that you can tap into as a company that allow you to stay private without having to tap the public markets for capital. ⁓ so that’s kind of
Why I think in a lot of ways the you know, these these IPOs of ⁓ OpenAI anthropic SpaceX are exciting is you you don’t see them every day. You don’t see them every year, even. It feels like maybe once a year we have one of these types of things. So I do think that that creates demand. And to your point, if only a very small float is available for the public, that even couldn’t even, and I think there’s some research to suggest that it will drive prices up even more potentially, at least in the short term.
on the day that it it goes public.
IPO Waves and Market Timing (4, 5) – Why companies may choose to go public when public-market prices, sentiment, and funding conditions are favorable.
Marcus Schafer (07:53)
Yeah, for people that get the IPO price. ⁓ and to to your point, you know, the last time we saw a big wave of IPOs kind of come out, there was a lot of research done after that, because that was during the internet, what we now call the dot com bubble, right? There’s a reason for it. Well, right afterwards, there all this research came out to try and understand exactly what was happening. Because if you look back in the late nineties,
You do see a ton more IPOs. You see a lot more IPOs going out and like the large cap space for what large cap was at that time. You don’t see like, hey, a company is private and now it’s the 10th largest company out there, but you definitely see these dramatic amounts just in terms of volume, both in numbers and also dollars ⁓ happening. And what’s interesting is
Some of the research that looks at, well, why was this happening? It’s because stock market prices were high. There was a lot of hype. What does high stock market prices mean? It tends to mean lower future returns. So the research goes on to say, hey, essentially, this is maybe one of the best forms of market timing that there’s evidence for. And it’s not for the investors, it’s for the companies themselves.
Saying, hey, I guess one of two things might be driving this. One, they can’t get the private capital ⁓ at the dollars they need to fund these next amounts of innovation that could be happening. Two, they think it’s a really good time to go public because they will get a really good price relative to their future expectations.
How IPO Pricing Works (5, 6) – The role of underwriters, roadshows, allocations, and the tension between what companies want and what investors want.
Pat Collins (09:42)
Yeah, it’s a really great point. The it maybe maybe it makes sense for us to talk a little bit about the process of an IPO so everybody understands. Cause I think we’re we’re throwing around this term ⁓ IPO. And obviously it means an initial public offering. But I think it’s good to step back and understand who are the players, how do you participate in it, ⁓ and and what does that look like. And then we can kind of get into what the research talks about ⁓ when it comes to IPOs. So just first talking about
The IPO process itself. A company that wants to go public, there’s obviously filings and things that you have to do to kind of present yourself to the public, but ultimately you’re choosing typically a bank, an investment bank to take you public, an underwriter. And they go on what’s called like a roadshow where they will go around and they will basically talk about how great your company is and try to drum up interest from investors. With a company like SpaceX, it’s fairly easy to drum up interests.
But there’s as you to as you pointed out, there’s lots of companies that go public every year that you never heard of. So this process of trying to find investors that would be interested in invest in investing in this new public company is a process and they charge hefty fees to do that. ⁓ typically, what we tend to see is that they are setting a price for investors, and that’s kind of what pe what investors get allocated at. So they might say, we think.
That the valuation of this company is going to be $100 a share. And typically they’ll set the price a little under that to kind of incent people to invest. So they would say, maybe we’re going to give you a $90 a share purchase price or allocation price. And the hope obviously is that that entices a lot of people to invest. And therefore, then, you know, you know, they’re able to fill kind of what they need to fill.
It’s an interesting dynamic of what’s happening because when you think about from the company’s perspective and from an investor’s perspective, there’s very dueling incentives here. So from a company’s perspective, you want to get the highest price possible because obviously all of that money is being funded, is helping you fund your operations. This is not secondary market trading at this point. This is we’re trying to raise capital for our business. We’re selling shares to the public.
So we want to raise as much as we can. So they want to set the price as high as possible. Investors want to buy it at the lowest price possible. What I love about public markets is that there are buyers and willing buyers and sellers that are coming together every single day and setting the price. The IPO process is not like that. There is an underwriter setting the price. There is no market forces that are working to set this price. So I do think that’s a little bit of a ⁓ challenge.
With IPO investing, is how do you know? How do I know if I invest in SpaceX and I get allocated shares? How do I know that’s the right price for SpaceX? I I I don’t really. I’m I’m hoping that the underwriters have priced it well. I’m really hoping that they priced it undermarket that as an investor. ⁓ obviously, SpaceX would rather have the opposite. They want it priced at the highest price possible so they can ⁓ sell less shares and get more money, basically. So
So that’s kind of the the the first step is this process of going out on a roadshow, trying to induce people to invest through, you know, through this kind of ⁓ market is basically I I’ve sat through many of these over my years, marketing kind of exercise of learning about all about the great things about this company and why they’re gonna outperform in the future.
Who Captures the First-Day Pop? (2, 3, 5) – Why the IPO “pop” is often measured from the offer price, not the price ordinary investors may actually pay.
Marcus Schafer (13:20)
The market pricing mechanism is what you describe. You get a bunch of people in the room, and essentially they’re thinking about what’s their price target? What do they think it’s worth? Now, what you don’t really know is all right, once this massive thing happens, is what I think the price is. Is that really going to be reflected? Is how’s that going to to pan out? So there’s a lot of uncertainty, which is why there is this this whole process. There was a really good ⁓ Wall Street Journal.
Article that kind of talks about what’s happening with SpaceX, talks about how all the investors are getting on planes and they’re going to visit the rocket making factories. And then they’re, you know, it’s not just a rocket company, it’s an AI company too, Pat. So now they’re going over to Memphis to look at the data center to help them get an idea of, hey, what’s the price going to be? And then how much do each of these people want to get allocated to? And what you see from the research, there does tend to be a day one pop.
People ask a lot of questions around, well, why would a company want a day one pop? I think the most logical thing is they’re going public because they think they’re getting such a good deal. They’re okay leaving some additional money on the table in exchange for the positive press that comes out of having their price go up on the first day as opposed to go down on the first day. That’s not a good indicator of the future of your company.
And then that article also talks about how IPOs have changed in the sense of the bigger they get and the more they’re spreading out these allocations, they essentially have to call each investor and be like, hey, you were you still are gonna invest a billion dollars, right? Okay, I’m gonna get you a billion dollars. And they got to go around to do that with a bunch of different investors. And that’s pushing back the time that these shares actually go publicly traded, which means investors like you or me.
can buy it, which might also increase the volatility because instead of saying going live at noon, now it might be two or three PM the day of there’s a lot of different investors. So do the systems work? There’s all all this uncertainty, ⁓ which might kind of compress more trading in less time, more volatility. Pat, maybe just also talk about how hard it is to get that IPO price allocation.
Pat Collins (15:46)
Yeah, it’s ⁓ you know, a a big a big determinant you’ve already mentioned is the float. So what percentage of the firm’s ⁓ its shares are going to be available for investing on that first day will will represent you know, so if you have a company, I I I think what I’m hearing about SpaceX is that it’s around five, four, four to five percent is what they’re talking about with the f with which is the float, which means four to five percent of the company’s outstanding shares, total shares are going to be available for investment that first day.
That’s a small amount. That’s just to be clear, that is a very, very small number. So now what they have to do is ⁓ you know, these underwriters ⁓ are now allocating these shares to companies, you know, like Goldman Sachs and Merrill Lynch and Morgan Stanley and all these big companies, Charles Schwab, Fidelity. And and then they are deciding which of our customers are we going to allocate shares to? And ⁓
There’s rules on this, but I can tell you that, you know, this is part of the process, having been through this. One, a lot of these companies will either impose ⁓ either, you know, directly or indirectly, some sort of lockup period where they say, Yeah, you can get these shares. We’re gonna allocate these shares for you, but you can’t sell them. You can’t sell them for 30 days, let’s just say. And so ⁓ the reason for that is they’re trying to avoid people just literally day trading these shares on the first day.
All the research says is most of the returns are made in IPOs on the first day. So ⁓ it’s one of those things that’s a little bit of a challenge if you’re investing in these IPOs. If you know, so they’re typically giving it to their largest customers. ⁓ the customers that generate the most fees will get allocations of these IPOs. the question is, is it is it good? I mean, obviously there’s there’s the IPO allocation price, which is what you pay for it before it starts trading publicly. Then
The the next step would be, well, let’s say I don’t get al an allocation of these shares. I’m not a gigantic investor at one of these companies. They don’t give me these ⁓ an allocation. How else can I participate? Well, as soon as it starts trading that day, I could just buy it. ⁓ now the question is, is at what price am I buying it at? How much different is that than the allocation price? And it tends to be pretty significant. I mean, I think the research showed that, you know, it can be somewhere in the
15 to 20% range of a first day pop. So meaning the allocation price, how that differs from what you can buy it at on the open market, basically. ⁓ and in cases where it’s a large IPO with very small float, it can go even higher than that. It’s kind of an interesting. I think there one of the research pieces that we read showed that large IPOs with a small float might have a 30% plus return on that first day. And
It gets me thinking of how much money I feel like these companies are leaving on the table with that kind of thing, where that’s money that could have gone into the company’s pockets to invest in RD and and grow their business and create jobs. But in fact, that 30% stayed in the investors’ pockets, basically, which again, if you’re an investor, great. If you’re a company, not so great. But yeah, this process ⁓ is an interesting process. It kind of happens behind the scenes, having been at a large brokerage firm.
They’ll have an IPO that they’ll even they’ll take it down to the office level and then say, for this office, we’re going to allocate a hundred thousand shares. And then you kind of have to grovel as an as an advisor to say, I have a client that really wants this or whatnot. And so it’s this long drawn out process. but at the end of the day, what I think happens most of the time is the largest clients tend to get the allocations. I still think it remains to be seen after the lockup period.
whether or not it’s actually good. It feels fun in the moment and feels like this, you know, ⁓ exciting process that you’re getting first access to a to a company, but I’m not sure that the data plays out that it’s a great long term investment.
Marcus Schafer (19:40)
You mentioned lockups. So maybe I’ll just walk through what that is for the investors already owning shares of these IPOs. when they go public, not they cannot share, they cannot sell all of their allotment. So they might have six month allotments, they might have shorter allotments. So these are companies like people like the CEO or long term shareholders, right? So there’s gonna be these lockups where you can’t even do anything if you want to.
So that’s one level of liquidity constraint. Then there’s a second level of liquidity constraint, which is what the underwriter, this is the investment banker that’s trying to control this process is doing. And when they’re calling companies saying, Hey, would you like to invest a billion dollars? They want to sell that billion dollars to somebody that’s not gonna turn around and dump it on the market. Because what do they want? They want that IPO pop. And if you dump a billion dollars,
That might not mean you get the same big day pop. So when you were talking about, hey, there’s typically this one day pop, low float might mean 30%. If it’s higher float, that might mean less, but it’s still meaningful. It’s still 10 to 20%. It’s not like they left 10% of $2 trillion on the table. They left 10% of 10% on the table ⁓ type of type of math. But they really like there is.
You know, it’s interesting. There’s a lot of focus around making sure they set the conditions to create these these one-day pops. So if you look at the research and you exclude those one-day pops, the performance of IPOs in aggregate is not good. And that’s not saying that there’s not IPOs that have done well. It’s when you take all the IPOs and you look at the longest data, and even when you kind of exclude the internet.
Pop. Even when ⁓ you look at kind of well, let me take the new millennium. When you cut the data different ways, you still see underperformance relative to a kind of market cap weighted portfolio, whether that’s total market or just small caps, ⁓ you still see very significant performance differences of negative a few percent to in some cases, depending on.
How you cut the characteristics, terrible, terrible performance, like negative twenty-five percent, if you’re truly trying to say, let me find the closest comparable group of peers to this company based upon some metrics.
What the IPO Evidence Shows (2, 3, 5) – What decades of research suggest about first-day returns, longer-term returns, low-float offerings, and IPO characteristics.
Pat Collins (22:15)
Yeah, there’s a study by a couple couple people, Ritter and Welsh, that looked at this. They probably have the it looks like the longest running study I I found. So they’ve they just recently updated ⁓ 1980 to 2024. So we’re looking at ⁓ 44 years of data of looking at all IPOs that have come out of the market.
What they found was on average, first day returns were 18.9%. So that’s that pop that we were talking about. So that’s the average. Some are better than that, some are worse, but that’s pretty good. ⁓ unfortunately, very few people are realizing that because they have these lockups. You know, they can’t sell it after that first day. So then if you look at it ⁓ and say, well, what what happens if you hold on to this IPO? the average three year ⁓ market adjusted return.
were negative 20.5% over over three year stretch. That means that it’s trailed the market by 20%, basically, in cumulatively. And then if you say, well, that’s not fair. These are tiny little companies, why would you compare it to like the Googles and the Nvidia’s of the world? So if you then just say, well, I’m going to adjust it and only look at the like a small cap index kind of thing, it still underperforms by 8.9% accumulative over those three years. So to your point,
Not good. If we go back to last last episode that we had around thinking around decision, you know, making good decisions. What this is not saying is that all IPOs are bad. We’re just saying in aggregate, they are worse, they have historically done worse than the market. And so as an investor, we should really take that into account. It doesn’t mean we can’t invest in the SpaceX IPO and make a lot of money.
⁓ we might. It we don’t know, but we know that’s probably a bad decision with a good outcome. Is if you if we if we were just a pure raw look at the data here. So I think that’s a really important element for people to to understand.
Marcus Schafer (24:12)
Yeah. And Pat, were you quoting the offer price numbers or the the after the first day close numbers?
Pat Collins (24:19)
It looks like it’s offer price from what I can tell here.
Marcus Schafer (24:23)
So there’s Ritter is like the famous academic that just studies IPOs. So he’s kind of this is what he does. And he’s been doing it for like 30 years. And you see this this offer price number, and you’re like, hey, it might be good. It seems like a good case. Some you see a lot of negative numbers relative to the market or relative to what he calls style adjusted. That means controlling for these factors of expected returns that we’ve talked about before. And then if you look at the
After from the first close, almost everything goes goes negative. Now it’s not to say to your point, ⁓ these are averages, right? So how can we dig a little bit deeper? And this is where those factors of expected return come into play. So, what are some characteristics of IPOs that might be more favorable to give the benefit of the doubt? And it’s the same factors of publicly traded companies, right? If you’re a large company,
You have a lower expected return. One of the big ones that’s really easy to tell is about profitability. So is a company profitable or is it not profitable? That really helps skew the data. It still doesn’t make a case for buying profitable IPOs at the close. Still doesn’t really make make a great case for that. But what it does tell you is: hey, if a company is profitable, which according to the offering documents, SpaceX is not.
⁓ expected to be to be profitable, that would have made a a stronger case. So there’s a few characteristics. You talked about free float, meaning if a company’s willing to put more of its shares on the open market, there’s a higher likelihood you might get better returns ⁓ in the long run, less returns in the immediate term. But yeah, these these factors that we think predict long, long term expect returns, we see them in IPOs as well.
Yeah.
Pat Collins (26:22)
I think
if you have an interest in this, we we we’ve talked about this in several episodes. We had one a few episodes ago around ⁓ factor returns is kind of what we call it. But it’s it it’s exactly right. There are research has shown that there are ⁓ factors that really influence stock returns over time. And IPOs tend to have all of the worst characteristics when it comes to factors. So ⁓ maybe not all, but a lot of them, which is low profitability. That not all, but a lot of them have.
Very low or no profitability for that matter. ⁓ they also tend to invest a lot in their business. So they can’t distribute cash flow to investors. They can’t, you know, they they have a capital intensive business. SpaceX, OpenAI, Anthropic, great examples of that. When you look at their their business of how much money they’re investing in data centers and all sorts of infrastructure, it makes it
harder, obviously to you know, w when you look at these factors, investment being one of them, does a company have to use a lot of their capital to reinvest in the business? it’s not a great trait. So ⁓ all reasons why it’s you have to be careful investing in these IPOs. I I do think maybe even taking it a step further for our for clients of Green Spring, but also just in general, I think a lot of people have, at least probably a lot of our audience, have
decided to invest in the markets through kind of broad market index funds or some other way to kind of own the market, basically, rather than try to pick stocks. Those stock pickers that are listening to our episodes are probably very, very disappointed. So I think the people that are listening are the ones that maybe ha are are agree with us. So I was I I thought it was interesting in doing the research of
Well, how do these indexes think about this? You know, a SpaceX comes on the market and is immediately the eighth largest company in the world. Do they do they get included in the index immediately? Or how do these companies so ⁓ you know, we looked at it. Do you have any thoughts on that? Because I think there’s some really interesting, you know, I I found it interesting on how each of these indexes look at these things.
How Diversified Investors Get Exposure (7) – Why investors may already benefit through indirect ownership and public companies that finance, supply, and partner with the next big thing.
Marcus Schafer (28:30)
Yeah. So if we summarize, hopefully we convinced people that ⁓ we do not believe buying in at IPOs is a smart decision. That leads you to this natural question, which is hey, if they’re a part of the market, I should own it, right? And the answer is yes. And what we’re talking about is how to be thoughtful about the timing of how you own it. And there’s three different ways you can think about capturing some of the economic benefits.
Of these companies without participating in the IPO. One is if your investment, when do they actually start buying, which is what you’re talking about, index inclusions, or when does it become eligible? That’s one consideration. so let’s talk about that. Second consideration is going to be do you already own stuff that owns shares of these private companies? ⁓ and
You know, not spare the lead. Yes, you actually already own shares of these companies if you’re a diversified investor. And then the third thing, which you also probably have exposure to if you’re a diversified investor, is do you own other companies that are economically benefiting from the innovation that’s happening? And yes, you you already own. So I think there’s three different ways that you’re still going to be getting benefits that you don’t have to take this.
Low expected return, high concentration, buy at the IPO price to get. ⁓ so what you’re talking about, Pat, if we just want to focus on it, this is the index inclusion. And there’s actually been a lot of conversation about this because these are such a big, you know, it’s to your point, it’s very rare to have so many companies go public at such a high market cap. We’re talking like the market cap of other countries, by the way, that
All these index companies, they’re asking this question themselves, which is, well, when’s the right time to add this? ⁓ and there’s a few considerations that that they’ll be thinking about.
Pat Collins (30:35)
Yeah, you know, I think looking at we we looked at SP, which is probably one of the most famous index providers, SP five hundred. They also have they have a number of indexes. but their rule is basically it needs to have 12 months of trading before it gets included in an index. So theoretically, SpaceX is not going to be included for the next year, or Anthropic or OpenAI in the SP 500, even though it could be in the top 10.
Of largest companies. The S P 500 represents the 500 largest companies. So that’s just a rule. It kind of goes back to our, you know, index investing is not truly passive. There is decisions that these index providers are making on whether to include or not include a stock. And that’s kind of an active decision. So to say that we’re purely passive when we own the SP 500 is not really accurate. But expect if you’re an S P 500 ⁓ shareholder or owner of a fund that invests in the SP, you’re
probably not gonna have exposure directly in these ⁓ stocks for for some, you know, period of time ⁓ for the first year or so.
Marcus Schafer (31:37)
Yeah, there’s, you know, you have to be traded for a while. Then there’s for the SP five hundred, there’s also a committee, right? They they have to do it. And then the third big hurdle point for them is you have to be profitable for four quarters to be eligible. The most recent example we have of this, and this is why we just think indexing’s great. It’s better than most other alternatives, but be cautious. The most recent example we have.
Of a very large company being added to the SP 500 is Tesla. And what happened when they added Tesla is they hit that four quarters of profitability. The secretive committee got together and said, we can’t ignore this any longer. We’re going to add Tesla. They’ve met our criteria. And you know what happened? The stock ran up in price a ton. But it’s not, if you’re an SP 500 index zone, you didn’t get that because it’s not added yet.
So what was happening? Front running was happening. A lot of these, everybody knows, hey, on this date at this time, there’s gonna be a lot of buying of Tesla. The stock went up, I think like 30 or 40 percent, if I remember exactly what happened before it was added. And then the moment it was added, subsequently dropped five percent.
Pat Collins (32:53)
It it’s the real downside of index investing is that, you know, we’ve talked about this in prior episodes. If you’re interested in really digging into how, you know, this is definitely in the weeds, some kind of nerdy investment talk, but how index gets ⁓ you know gets created, but then also gets traded. And there’s a lot of smart people in the market that understand that Tesla is going to be included in the SP. That means that.
Billions and billions of dollars are all going to have to pour into Tesla to include it. You know, they have to own it inside of their fund and they get ahead of it. And they basically bid up the price prior to that, knowing that people are going to buy at that price because an index investor doesn’t care about price. They care about it matching the index. That’s the you know, that’s the important part. So, you know, SP obviously has specific rules. All the index providers have their own. We saw another one, FTSE, which is another big global fund.
allows IPOs to start trading after five trading days. They can they can put that into their index. ⁓ MSCI has a different methodology. It seems a little bit more kind of ⁓ discretionarily by committee. So it it is likely these bigger companies, you will eventually own them directly. It’s a question of when and how and at what price are you getting them at, I think is the other part. So we tend to favor
Companies like Dimensional Funds or Avantis, which has got a little bit more flexible trading philosophy and either inclusion, exclusion, or when to start adding it, and trying to keep in mind of all these kind of downsides of just automatically including in an index and getting this front running that you talked about. And ⁓ so I think that’s a it’s an important aspect of thinking about what type of index am I investing in and how does it participate in IPOs? And is that adding or detracting from the portfolio?
Marcus Schafer (34:40)
Yeah. It’s ⁓ it is incredibly challenging. And I don’t I I think it’s really hard for these index providers. Something like two trillion dollars tracks the crisp US market. That’s Vanguard’s big US market tracking solution. So when they’re allocating, they’re talking tens of billions of dollars on any given purchase. Vanguard owns something like 10% of every single stock ⁓ out there in the US. So
When they’re making these decisions, they know there’s going to be implications and they’re trying to build into the rules ways to protect themselves. So they’re thinking about these fast track inclusions, which is, hey, you know, can we make exceptions when they’re exceptional IPOs? Okay, that’s a decent framework. The challenge is it’s really hard. And you’re kind, you’re kind of weighing these two things, which is the mandate you’re given from investors is to represent the market.
So you want to own everything as quickly as possible, but you also are looking at the same research everybody else is looking at. And you’re saying, I want to own positive expected return companies. So they’re trying to balance this and find a find a middle ground. And there’s a lot of there was a lot of conversation about exceptions to some of their some of their rules and whether or not that would help them win the listing business. And I think it just goes to show.
That again, these are these are minor different. I you know, it’s they are big, but it’s gonna be smaller pieces of total performance. But it goes to show because we’ve solved so many aspects of investing, we’re now at this nitpicking phase and there’s value to be had. ⁓ somebody did some research around Crisp, ⁓ how they think about fast tracking and all these other considerations. It’s multiples of the expense ratio.
So these are big outcomes relative to the expense ratio, but only because we’ve driven expense ratio is really, really low. So yeah, it’s it’s really, really important. The narrower your index you’re gonna be looking at, I would expect a bigger risk or outcome. You know, if you’re thinking a total market US strategy that owns 3,000 stocks, okay, it’s it’s gonna matter, it’s gonna be less.
The SP five hundred is gonna be more impacted. Something like NASDAQ, which is a hundred stocks, I think would be more impacted by by these decisions compared to other indexes that might be more diversified.
Pat Collins (37:14)
Yeah, absolutely. I think ⁓ I think we’ve probably exhausted the ⁓ the IPO ⁓ kind of landscape here, but I think there’s some takeaways that I I thought we could leave ⁓ our audience with. ⁓ may maybe some of the most important things that I that I see. One is just going back to, you know.
Trying to make the best decision you can with the information that you have. And so I think the the data says if you are getting an allocation of these shares, if you’re able to get an allocation, there’s some evidence to say that it’s may not be a bad thing. We this is a large IPO, all three of them, with fairly small floats. ⁓ it may not be the worst thing in the world. ⁓ if you were trying to buy at the open or buy in a secondary market after they go public.
Then the data is really ⁓ is a much more clear in my mind that it is on average not a great investment decision compared to investing in the market in general. So ⁓ hopefully people can take this data, make a good decision ⁓ with what to do about these IPOs. Our suggestion would be own the market. You will eventually you already have exposure to your point. Open AI has a massive investment from Microsoft in inside of it.
Google owns SpaceX. you know, you are getting exposure to these companies just through your regular public investments. And eventually your market index fund or your market, you know, your fund that tracks the market is going to own these directly as well. So you will get exposure to them, but trying to do it individually, we feel like is probably not the best, best bet for most investors.
Marcus Schafer (38:51)
Yeah. And, you know, the the other thing is ⁓ there’s other economic benefits that I think are really, really huge. I don’t think it makes sense to buy the IPO. I would even, I guess I’m more cynical if you could get access at the IPO price. I would wonder what other fees you’re paying ⁓ and why somebody would give you that access because it’s such a good screaming deal to publicly traded companies have corporate.
They call them CBCs, corporate venture capital arms that are investing in private companies that they think could be ⁓ beneficial to their business. And then three, look at the whole stock market across the globe and think about all the volatility we’ve had this year when it comes to headlines. Benefits seem to be accruing across the economy, ⁓ at least in terms of stock prices. So
That’s another comforting sign. Hey, which I think is actually ironic when I was thinking about this episode, which is diversified investors probably stand a much better chance of getting exposure to these few IPOs and the economic benefits of them than somebody sitting in cash waiting to to find a way to pay really high fees or jump through a lot of a lot of hoops to get this to get this exposure.
Pat Collins (40:16)
Great, great comments. I I love that comment because you’re absolutely right. Cause I saw it firsthand that people that are getting access to these things, you can probably through the through the IPO allocation. I would take a further step back and say, why am I getting an allocation to this? It probably means I am a great customer to this bank or this brokerage firm. That means I’m probably paying very high fees. So you know, if you are getting lots of allocation, just be careful, take a look at what’s going on with the rest of your portfolio.
The Other Side of the Trade (1) – Why employees, early investors, and concentrated shareholders may be trying to reduce risk at the same time public investors want to add it.
Marcus Schafer (40:45)
Yeah. And one one last comment because I can’t help myself, but I’m always reminded of ⁓ Mark Cuban when he sold his business to Yahoo. And when we’re thinking about talking with investors in similar situations, here’s the stories I’m hearing from advisors, employees of these companies, they’re thinking about what Mark Cuban was thinking about, which is hey, a lot of my net worth is tied up in this one big thing. How can I protect myself? And the reason why Mark Cuban has a lot of money still.
And got to own a sports team is because he did essentially the opposite of the IPO investors. He was going the other other way and trying to figure out ways to get protection. So that’s another, I think, decision making framework going back to our last episode, which is okay, put yourself in the shoes of one of these employees. Why would they why would they want to sell if it’s such a such a good deal to own these? Because they know there’s there’s a lot of risk and concentration. You should factor, factor that in. All right, Pat.
Thanks for this. This was fun.
Pat Collins (41:45)
Yep, absolutely.
Sources
- Greenspring Advisors, “5 Tools for Better Decisions | The Decision Dividend #34.”
https://www.youtube.com/watch?v=4WEK-1gMFd0 - Jay R. Ritter, “IPO Data,” University of Florida.
https://site.warrington.ufl.edu/ritter/ipo-data/ - Dimensional, “What to Know About an IPO.”
https://www.dimensional.com/us-en/insights/what-to-know-about-an-ipo - Luboš Pástor and Pietro Veronesi, “Stock Prices and IPO Waves,” NBER.
https://www.nber.org/papers/w9858 - Jay R. Ritter and Ivo Welch, “A Review of IPO Activity, Pricing, and Allocations,” NBER.
https://www.nber.org/papers/w8805 - Wall Street Journal, “SpaceX Is Aiming for Civilization on Mars. Its IPO Couldn’t Be More Old School.”
https://www.wsj.com/finance/stocks/spacex-ipo-process-preparation-69f97465 - Dimensional, “Hiding in Plain Sight: Private Asset Exposure Through Public Equities.”
https://www.dimensional.com/us-en/insights/hiding-in-plain-sight-private-asset-exposure-through-public-equities
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