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 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 in 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 writes in the study. “Furthermore, new cohorts operate in product markets characterized by higher uncertainty and competition.”
In part, this is nothing more than the flip side 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 has seen its lunch eaten by Apple, 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 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.
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.
James Saft is a Reuters columnist.