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Economic Insights

What does the sharp increase in initial public offerings signal about the stock market's valuation?

The powerful increase in initial public offerings (IPOs) signals investors in two ways. The most conventional reading is that equity markets are beginning to approach full value. After all, firms come to market when they can get better prices. But at the same time, the nature, size, and particular causes of recent IPOs raise questions about any such general interpretation. For the time being, then, the picture conforms to the judgment made by Lord Abbett in this space and elsewhere that the market, though not as drop-dead gorgeous as it once was, is, nonetheless, still attractive.

Powerful Momentum
IPOs have always closely followed market pricing, falling in market retreats and rising as valuations get richer. During the market crash of 2008, for example, private firms saw little return to a public offering.  Only 27 companies went public in the United States that year, 95% less than in 2000, when more than 500 companies went public. The number has picked up with market gains. In 2010, after the economy began its admittedly substandard recovery, 136 companies went public. In the first half of this year alone, though, the figure has jumped to 165. If this pace holds for the rest of the year, 2014 will record 330 IPOs, a 100% increase over last year.1

If this jump clearly shows confidence among investment bankers and business managers that the market is more fully priced than previously, it would go too far to attach a word like “exuberance” to their attitudes. After all, today’s volumes, though smartly up from last year and certainly from 2008, remain well below levels of the late 1990s and 2000, when words such as exuberance and overvaluation did indeed apply to equity investors and prices. Even if the first half pace continues and 2014 does see 330 IPOs, volumes would remain only two-thirds of the 500 IPOs recorded in 2000 and less than half the 724 IPOs averaged in the United States in 1996 and 1997. The enthusiasm, though becoming more evident, is nowhere near where it was when the market was clearly approaching an overvalued state.2

Nature and Causes Diminish the Implicit Warning, Too  
The clustering of recent IPOs also warns against generalized interpretations. More than half the offerings recorded this year so far have been in technology and biotech. These are areas noted by investors—and no less a personage than Federal Reserve chairperson Janet Yellen—wherein pricing clearly has exceeded fundamentals. It stands to reason, then, that biotech and tech companies would rush to cash in, or rather out, when they could get outsized prices. This skewing, however, suggests that such urgent pricing considerations are not so prevalent elsewhere.

The capitalization mix of IPOs also suggests that something other than generalized pricing gains are driving the aggregate activity. Of the 165 IPOs recorded during the first half of the year, most leaned toward larger deals. Less than 7% were valued below $50 million, and only 22% were valued below $1.0 billion. This is a very different picture from periods of generalized IPO enthusiasm over high stock prices.  Between 1991 and 1997, for instance, some 80% of the 3,000 IPOs recorded during that time were valued at less than $50 million.3  Commenting on this situation in testimony before Congress some months ago, David Weild, former vice chairperson of NASDAQ, noted how the United States led the world in small-capitalization IPOs in the 1990s but, despite still having the worlds’ largest gross domestic product (GDP), the United States ranked twelfth for such offerings more recently.4

This relative lack of smaller-capitalization IPOs is stranger still when considering the likely effect of the 2012 JOBS Act. Noting that smaller firms are the economy’s key source of new employment, Congress passed this piece of legislation, formally titled the Jumpstart Our Business Startups Act, to channel more capital to smaller firms. 

The bill offers five basic concessions to those the act refers to as emerging growth companies (EGCs), that is, firms with less than $1.0 billion in annual revenues: 1) the act smooths the IPO “on ramp” (to use Washington’s fun language) by gradually phasing in required compliance measures over time; 2) it allows confidential submissions of IPO registration statements with the Securities Exchange Commission (SEC), presumably to give managements more flexibility in timing their offering; 3) it exempts such firms from many of the usual disclosure statements or scales in such requirements; 4) it lifts restrictions on so-called “test the waters” communications among firms and qualified institutional buyers (QIBs) and institutional accredited investors; and 5) it relaxes restrictions on research at the time of the IPO, effectively reversing many rules adopted after the dot-com bubble burst in the early 2000s.5         

Meanings?
With such support, it is little wonder that IPO volume picked up in 2013 and 2014. The wonder is that it did not pick up more dramatically and that such a relatively small percentage of those coming to market were EGCs. The general impression, then, is that this IPO surge differs from the sort that would otherwise signal an overvalued market—a more fully valued market than previously, to be sure, and one with pockets of overpricing, but not a sign yet of general overvaluation. Stocks, then, would seem to offer more upside. Investors should nonetheless watch IPOs for signs when there is a truly full valuation. 

 

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