When the Rocket Launches Without You

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“The important thing about an investment philosophy is that you have one you can stick with.”   – David Booth

 

Every few years, an IPO comes along so large and so talked-about that it tests whether you actually believe in your investment philosophy … or merely believe in it when it’s comfortable.

This is one of those moments. SpaceX has just gone public in one of the most anticipated listings in market history, with OpenAI, Anthropic, and others reportedly waiting in the wings. The headlines are loud. The temptation to “get in early” is real.

At Sterling, we don’t chase IPOs …and the “why” matters. Research has shown that IPOs as a group have historically underperformed the market.  According to Dimensional Funds research, a hypothetical basket of IPOs (defined as companies who’ve gone public[1] in previous 12-month periods, rebalanced monthly) compared to the market, provided the following returns across time periods[2]:

IPO Returns Analysis (1992-2024)

IPOs Russell 3000 Index
Annualized compound return 5.13% 10.44%
Annualized standard deviation 28.11% 15.00%

Our portfolios, built around an evidence-based approach, are flexible enough to generally exclude newly issued public companies from equity strategies for up to a year after they list.  However, we may utilize some index funds for clients that provide excellent diversification but which may “fast track” IPO inclusion, which is beyond our control. To the extent we can control for IPO exposure, we will definitely strive for this approach. This isn’t timidity. It’s a deliberate, research-driven decision that has historically added to returns, not subtracted from them. (For more information, listen to this podcast IPOs: Profiles Are High, What About Returns?)

It’s worth two very different things: the exuberance around an IPO and the return of an IPO. They are not the same … and they often point in opposite directions.

There’s a structural reason for this, and it has a name: adverse selection. When a “hot” IPO is oversubscribed, the most sought-after shares are rationed, and ordinary investors tend to get full allocations precisely in the offerings that insiders are least excited about. You reliably get more of what’s least wanted and less of what’s most wanted. That’s a quiet, persistent headwind … and it’s one reason we’d rather let the dust settle.

What’s Special About “12 Months”?

Often the waiting period for IPO inclusion in various investment strategies is thoughtful on the part of the manager as a newly listed stock spends its first months in an unusual, somewhat artificial environment, and a great deal can happen before its price reflects reality. What is going on?

  • ‘Tacit’ Price Support – In the weeks after an offering, underwriters often provide price support, gently propping the stock price up.
  • Lockups – Company insiders and early investors are typically bound by lockup agreements. These agreements are promises not to sell their shares for a set period, often around 180 days, sometimes structured to expire in stages. When those locks expire and a flood of previously restricted shares can finally be sold, the supply-and-demand picture can shift sharply. Waiting for the lockups to lift and the underwriter activity to fade lets the market do its real work … discovering a price the company actually deserves, rather than the one the launch-day enthusiasm produced. This is sometimes referred to as “lockup risk”. We can control that so we try to avoid
  • Historical Underperformance – As a group, IPOs have historically lagged the broad market as noted above. The excitement rarely translates into superior long-term returns for lifetime investors.
  • Liquidity Risk – A newly public stock with fewer shares trading in the open market can be difficult to trade in size without moving the price, in either direction. This is called the float, and it is the slice of shares available to the public, as opposed to those shares still locked up or closely held.

None of these points means an individual IPO can’t succeed. Some, of course, do, and spectacularly. But our job isn’t to find the rare rocket that reaches orbit. It’s to build an all-weather portfolio that doesn’t depend on us guessing which one will.

The IPO “Madness” In the Markets Today

Several major index providers (Russell, MSCI, and CRSP among them) have changed their rules to “fast-track” giant new listings like SpaceX into their indexes within days or weeks of going public, rather than making them wait. That sounds dramatic. But here’s how these IPOs will show up in index funds: index funds weight companies by their float, not by their eye-popping headline valuation.

SpaceX is an enormous company on paper, but it has sold only a small sliver of its shares to the public. So even as it enters a broad large-cap index, its initial weight is likely to be a fraction of a percent on the order of 0.08% to 0.12% in a broad large-cap benchmark…a trillion-dollar name, entering at roughly a tenth of one percent.

Of note in this environment: Standard & Poors (S&P). S&P has kept its existing rules in place, which require a company to be profitable on a GAAP basis before joining the S&P 500. SpaceX doesn’t currently meet that bar, which means, barring a change, it can’t enter the S&P 500 until it posts the required profits, likely no earlier than 2027. We mention this not to handicap the outcome, but to illustrate a point: thoughtful, rules-based investors can look at the very same company and reasonably decide to wait.

What is The Market?

Here’s something that distinguishes our approach and is worth retelling. As “evidence-based” investors, we don’t outsource our definition of “the market” to any one commercial index provider.

We define and adjust our investment universe according to financial market research and a sound management process. The Sterling approach will sometimes exclude securities the indexes hold, and include securities they don’t, when the market research leads that way. And we make those choices as a fiduciary to our clients. This is a responsibility the index providers themselves are quite clear they do not carry. They are, by their own admission, not fiduciaries. We are.

What This Means For You

Warren Buffett put the temperament of disciplined investing about as well as anyone: “Be fearful when others are greedy, and greedy when others are fearful.” IPOs are where investors are most often excited to be a part of the action. Our instinct, grounded in decades of evidence, is to let the excitement pass and let prices find their footing.

So…when you read about a launch you weren’t part of, we hope you’ll feel something closer to calm than regret. Sitting out the frenzy isn’t missing out. It’s the same patient discipline that lets us focus relentlessly on the things that actually compound your wealth over decades: broad diversification, low costs, tax efficiency, and a plan steady enough to hold through every season of life. Those are the levers we can control. We’d rather pull them every day than chase the rocket that may or may not reach orbit.

 

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[1] https://www.morningstar.com/podcasts/investing-insights/brace-your-portfolio-mega-ipos-2

[2] https://www.dimensional.com/us-en/insights/ipos-profiles-are-high-what-about-returns

Source: Dimensional using Bloomberg data. The sample includes US market IPOs, including US-domiciled companies and foreign-domiciled IPOs in the US, with an offering date between January 1, 1991, to December 31, 2024. Excluded from the sample are IPOs with an offer price below $5, unit IPOs (common stock and warrants), and IPOs involving real estate investment trusts, closed-end funds, American depository receipts, partnerships, and acquisition companies. The hypothetical IPO portfolio is formed December 31, 1991, and is rebalanced monthly to include all firms with an IPO during the prior 12-month period. Weights are based on prior month-end market capitalization. Frank Russell Company is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indices. Indices are not available for direct investment; therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.

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This article is for informational purposes only and does not constitute investment advice. Past performance is not a guarantee of future results. All investments involve risk, including possible loss of principal. International investments involve additional risks, including currency fluctuations and political instability.