Why are new listings so volatile?

Posted by Robin Powell on May 20, 2016

For most investors, buying individual stocks is a bad idea for a number of reasons. But there’s growing evidence that newly listed companies in particular are worth avoiding.

New listings inevitably receive a disproportionate amount of media attention; they are, by definition, “news”. But they’re also increasingly volatile. For example, a company listed in the US before 1970 has a 92% chance of surviving the next five years, compared to just 53% for a company listed between 1990 and 2000.

Of course, no new company can expect a smooth and steady ride. Disrupting established markets, or just breaking into them, is inherently risky. Some academics have also suggested that new companies often go public before they’re ready, while others say that today’s investors have a higher tolerance of risk.

But new research in the US suggests there may be a more fundamental reason why newly listed stocks have become more volatile. In a paper entitled Why Are Successive Cohorts of Publicly Listed Funds Successively Riskier?, Anup Srivastava from Tuck School of Business in New Hampshire and Senyo Y. Tse of the Mays Business School in Texas point to the shift from an “infrastructure-intensive” production economy to one driven by innovation.

“The competitive advantage of these new firms doesn’t come from exclusive access to certain factories or natural resources,” says Srivastava. “(It) comes from ideas and technologies, and those can be lost very quickly.

“The fundamental distinction between firms that use tangible and intangible methods of production is that creative destruction happens much, much faster for firms that have intangible methods.”

Srivastava cites as an example of an “intangible-intensive” firm Tesla, the electric carmaker. “Tesla may have the best product in the world,” he says, “but it will take years for it to develop a network of suppliers, build factories and develop a service network. But if you come out with a better search engine, you can take over the whole world market tomorrow.”

Throughout market history, investors have been beguiled by new investing “opportunities”, new disruptive companies and whole new industries. But, as a general rule, it rarely pays to be at the front of the queue for shares.

In this video, David Chambers from Cambridge Judge Business School gives three historical examples of investors being caught out by so-called “new era thinking” — the railway boom in the mid-nineteenth century, the growth of the car industry up to the late 1920s and the Dotcom Bubble in the late 1990s. In each case, the potential for investors to profit seemed enormous at the time, which is why so many piled in. But the capital simply generated more output, which in turn drove down prices and stoked falls in share prices. In other words, each of these new innovations benefited consumers far more than shareholders.

Of course, share prices did recover after each of those bubbles burst, but even then, holding individual stocks in those emerging technologies was very hit and miss. In Britain, for example, hundreds of railways companies were launched in the 1840s and hundreds of car companies in the early twentieth century, but very few went on to be consistently profitable.

So, rein in your enthusiasm whenever you read about the “next big thing”. Sure, buy one if you want to, but don’t invest. A broad portfolio of index funds will give you as much exposure to innovative new companies as any investor needs.

 
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Robin Powell

Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.

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