Prof. Jay Ritter: IPOs, SPACs, and the Hot Issue Market of 2020 (EP.139)

Episode Summary

Executive Summary: Professor Jay Ritter, a leading expert on IPOs and SPACs, discusses the long-run underperformance of IPOs, the mechanics and risks of SPACs, and the surprising lack of correlation between economic growth and stock returns. He highlights the importance of valuations, the adverse selection faced by retail investors, and the role of skewness in venture capital. The conversation also covers market efficiency, the current low expected returns, and the dangers of chasing past performance.

Main Topics: IPO Performance and Underpricing (Priority: 5/5): Analysis of long-run IPO returns, first-day pops, and the systematic underpricing of IPOs. Ritter explains that while IPOs on average underperform, this is driven by tiny companies, and that underpricing is a global phenomenon with extreme periods like the internet bubble and 2020-2021. SPACs (Special Purpose Acquisition Companies) (Priority: 5/5): Detailed breakdown of SPAC structure, including the money-back guarantee for investors, the sponsor's 20% stake, and the role of warrants. Ritter discusses the recent explosion in SPAC activity, historical returns, and the risks of dilution and adverse selection for retail investors. Economic Growth vs. Stock Returns (Priority: 4/5): Ritter presents evidence that high economic growth does not predict high stock returns, citing examples like South Africa outperforming China. He explains that per-share earnings growth, not GDP growth, drives stock returns, and that valuations (P/E ratios) are critical. Market Efficiency and Behavioral Factors (Priority: 4/5): Ritter discusses the efficient markets hypothesis, acknowledging its usefulness but also its limitations. He highlights behavioral biases like chasing past returns and the psychological factors that lead to IPO underpricing and bubble formation. Venture Capital and Private Markets (Priority: 3/5): Ritter argues that private markets are not a great opportunity for individual investors due to adverse selection and high fees. He cites a study showing that average limited partner returns match public equities, and emphasizes the skewness of venture capital returns. Expected Returns and Valuation Metrics (Priority: 3/5): Ritter recommends using the Shiller CAPE ratio to estimate expected real stock returns, currently around 3% in the U.S. He notes that while expected returns are low across all asset classes, the equity risk premium remains positive, supporting diversified portfolios.

Key Arguments: IPO underperformance is concentrated in the smallest companies; larger IPOs tend to neither outperform nor underperform. Underpricing is driven by underwriters' incentives to reward institutional clients, not by issuer interests. SPACs offer a risk-free investment for IPO investors historically (9.3% annualized), but post-merger returns have been mixed and recent high first-day pops reduce the free lunch. Economic growth does not predict stock returns; per-share earnings growth and starting valuations are more important. Private markets are not a superior opportunity for individuals due to high fees and adverse selection. Market efficiency is a useful model but not perfectly correct; bubbles and mispricings exist, but timing them is extremely difficult.

Data Points: Average first-day return for US IPOs in last year: 40% - Highest since the internet bubble. Median price-to-sales ratio of tech IPOs in last 12 months: 24 - Up from historical average of 6 and 12 in 2018-2019. Number of SPAC IPOs in 2020: 248 - Raised about $80 billion, up from typical 50 SPACs per year. Average first-day return for SPACs in 2021: 6% - Compared to 35% for operating company IPOs. Historical annualized return for SPAC IPO investors: 9.3% - Risk-free due to money-back guarantee. Current expected real return on US stocks (Shiller CAPE): 3% - Inflation-adjusted, based on earnings yield. Real yield on 10-year TIPS: -1% - Implies equity risk premium of about 4%.

Pivotal Quotes: "The average limited partner in venture capital and buyout funds has gotten an average return the same as they could have gotten by investing in publicly traded stocks. The fees that the middlemen collect are big." — Jay Ritter: Discussing the lack of superior returns in private markets for individual investors. "If you can rationally say, you know, just about everybody considers me a nice person, I would view that as a big measure of success that's under your control." — Jay Ritter: Answering the final question on defining success in life. "The efficient markets hypothesis can be a useful way of thinking about things, but that doesn't mean that it's perfectly correct. You know, I wouldn't be shorting Tesla if I thought that the stock market was completely efficient." — Jay Ritter: Explaining his nuanced view on market efficiency.

Implications: Investors should be cautious about chasing IPOs and SPACs, especially retail investors who face adverse selection. The lack of correlation between economic growth and stock returns suggests that international diversification and a focus on valuations are key. Current low expected returns across asset classes reinforce the need for disciplined, long-term portfolio strategies.