(James Saft is a Reuters columnist. The opinions expressed are
his own.)
By James Saft
May 25 (Reuters) - Initial public offerings are getting
riskier and riskier, with increased volatility in earnings and
share prices.
This is not only bad news for investors in IPOs, but may
also have significant repercussions on equities generally.
Studies over the past decade have shown that successive
generations of IPOs through the decades are performing worse;
they grow more quickly than their forebears but with greater
volatility and more failures.
A recent study finds that this reflects heightened
competition as the world has moved away from simply making
things and pivoted toward producing higher-valued goods or
services, but in much more competitive areas.
"Firms from successive cohorts (of IPOs) enter more
knowledge-intensive industries. Even within the same industries,
successive cohorts use higher levels of intangible inputs," Anup
Srivastava of Dartmouth College and Senyo Tse of Texas A&M write
in the study. "Furthermore, new cohorts operate in product
markets characterized by higher uncertainty and competition." (http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2724081)
In part, this is nothing more than the flipside of the
globalization of manufacturing jobs to cheaper offshore
locations. That move away from commodity-type manufacturing
leaves U.S. companies to compete in areas with more intangible
inputs. When you compete on the strength of your talent, of your
technology and of your research and development, you are subject
to much higher volatility in the market than companies from an
earlier era.
That's clearly reflected in the performance of IPO cohorts
as documented in the study. Firms listed in the 2000s show share
price volatility higher than those listed in the 1990s, 1980s,
1970s or before 1970. Earnings volatility is also much higher;
for example, about 10 times higher for firms that went public in
the last decade vs those that went public before 1970.
Research and development spending has also moved higher over
time, while newer firms also use less in the way of material
inputs but must compete in more fragmented and competitive
markets. The study found that the underlying reason for the
changes in performance are the differences in operating
conditions.
While this is positive, in that it shows that companies are
becoming more innovative, the world of today offers less
security. So good for consumers, perhaps, but not so great for
investors, who must be prepared to endure a wilder ride.
So while today's IPOs innovate more, offering more new
products, this is because they must, as the markets in which
they compete are also innovating at a more rapid rate. That
greater rate of creative destruction is reflected in the higher
number of firms from later IPO generations that fail.
JUST IPOs OR THE REST?
Note too that this is all not simply a tech industry
phenomenon. While Blackberry BB.TO has seen its lunch eaten by
Apple AAPL.O , the study found that industries outside tech are
showing the same trends. Successive generations of companies in
a range of sectors are using more intangible inputs to create
value and are competing in more volatile and tougher
environments.
All of this may also help to explain why, while profits are
more volatile and more are failing, the distribution of profits
among companies is skewed more to the right, meaning there are
more very highly profitable companies.
Firms that rely more on intangibles, like talent and R&D,
tend to have higher fixed costs, which leads to higher losses
earlier in their life cycle. However, they find it comparatively
cheap to scale up production, which leads to profit monsters
like Apple.
Earlier studies have posited that the declining performance
of IPOs was explained by the age at which firms tend to go
public. As firms have tended in more recent decades to go public
earlier in their lives, they would, this argument holds, show
more volatility in performance than more seasoned firms.
If that were true, Srivastava and Tse argue, then risk
levels among newer cohorts should decline as the unviable fail.
"We find persistent and substantial risk differences across
listing cohorts even after several decades. In addition, we find
no evidence that new-list firms' operating characteristics
converge toward those of seasoned firms. The intangible
intensities and product market characteristics of successive
cohorts remain distinct," they write.
The larger question not answered by the study is what this
means for companies and equity investing generally.
My guess would be that it implies tougher overall
conditions, with greater distance between the performance of big
winners and the rest. Over time the economy itself is shifting
more toward areas with higher inherent levels of competition and
volatility.
Remember too: This is happening over an extended period. It
isn't just capturing a one-off rise in risk due to digitization
or the internet. This seems permanent and pervasive.
How investors price this rise in risk remains to be seen. We
probably won't get a clear view on this until interest rates
rise.
(At the time of publication James Saft did not own any
direct investments in securities mentioned in this article. He
may be an owner indirectly as an investor in a fund. You can
email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft)
(Editing by Dan Grebler)