As Shake Shack's recent slide demonstrates, while the IPO boom gives you lots of hot companies to take a flier on, you’ll most likely fall flat.
Do you regret missing out on the stunning debuts of Alibaba ALIBABA GROUP HOLDING LTD BABA 0.49% and Shake Shack SHAKE SHACK INC SHAK 3.38% ? Are you now waiting to hail Uber or snap up Snapchat when they go public, as expected?
Before you jump in, remember that when you pick a stock, you’re already taking a leap of faith—but with a newly public company, you’re taking two leaps. First, do you really know enough about the business? Second, has the market had sufficient time to draw its own conclusions so that you are buying at a fairly rational price?
“Anything that’s been trading for a while has been vetted by a whole host of investors,” says John Barr, a manager with the Needham Funds. Not so at or just after an initial public offering, and that’s why you have to tread carefully.
You’ll pay for the honeymoon
IPOs attract big headlines on day one, but surprises inevitably crop up. From 1970 to 2012, the typical IPO gained just 0.7% in its second six months, after the honeymoon effect had a chance to wear off. That’s five percentage points less than other similar-size stocks, finds Jay Ritter, a finance professor at the University of Florida. The year after that, the average IPO lagged by eight points.
Chinese e-tailer Alibaba, which soared 38% on its first day in September, is getting its dose of reality a bit ahead of schedule. Shares are down 28% lately, after the company surprisingly missed revenue-growth forecasts.
Themes get overdone
It’s easy to be lured by a story. Shake Shack doubled on its first day, thanks to the buzz surrounding high-quality fast-food chains like Chipotle CHIPOTLE MEXICAN GRILL INC. CMG 0.59% . But riding a food trend is hard. A decade ago, overexpansion killed investors’ ravenous appetite for Krispy Kreme doughnuts KRISPY KREME KKD 0.95% , and the company’s shares remain 56% off their peak.
Shake Shack has also entered a crowded battle for foodie dollars: the Habit Restaurants HABIT RESTAURANTS HABT 2.03% , Potbelly POTBELLY CORP COM USD0.01 PBPB 2.75% , and Noodles & Co. NOODLES & CO COM USD0.01 CL'A' NDLS 0% all went public recently, and all more than doubled in the first day. Odds are the market is overoptimistic about most of them. Since 2013, 15 stocks have doubled on day one; only two—both biotech firms—are trading above their first day’s close.
The fact is, unless you gain access to an IPO at a great price at issuance, you can’t view those stocks as buy-and-hold investments. And you should avoid any richly priced new stock altogether.
Shake Shack trades at 650 times its earnings. To justify that valuation, Ritter figures the burger chain must grow from 63 stores to nearly 700, each half as profitable as a Chipotle restaurant. That’s a big leap indeed, given that Shake Shack locations aren’t even a third as profitable at the moment.
This story was originally published in the April issue of MONEY magazine. Subscribe here.