Initial public offerings are back. Medibank Private is on the block in Australia. How should you approach IPOs and how can you tell a good one from a bad one?

An IPO is when a company first sells stock to the public. Sometimes, these offerings are by smaller companies seeking capital to expand. Other times, they involve large privately owned companies where the principals and other insiders are seeking to cash out of some of their investment.

In the case of the sale of Medibank, the IPO is a privatisation. This is when a government, often seeking to repair its budget or increase efficiency, sells a publicly owned asset. Small investors and institutions can buy shares and own a stake of the enterprise.

The bigger initial public offerings or company “floats” are often accompanied by slick publicity campaigns. These can include paid advertising, mail-outs and exclusive “drops” to financial journalists who are used to market the offer and maximise the price.

So there are lots of vested interests involved. The owners want the highest possible price, the underwriters and brokers want maximum publicity so they can clear the stock, the public relations and advertising companies want the business and the media wants the story.

Naturally, individual investors, when confronted by all the hype around IPOs, will ask their advisors whether it is worth buying stock in the initial offer.

The truth is no-one really knows whether the initial price is the “right” price or whether the stock will be a good long-term investment. It often takes a significant period of a stock trading in the secondary market before a number of structural issues related to the float are out.

These can include lock-up periods which prevent the principals and other insiders of a company selling their stock on-market. Knowing of this over-hang from potential future sales, the market can sometimes discount a stock in the months after the IPO.

On other occasions, the underwriters to the float may be contracted by the promoters to provide support for the stock in the initial months. So, again, it can take time for the security to fully reflect the risk and return characteristics of the company.

A third common issue is that institutional investors find they get generous allocations to less popular public offerings and minimal allocations to the really sought-after ones. When supply exceeds demand, think about what happens to the price.

Finally, the evidence around the performance of IPOs is mixed. Some companies do well. An example locally is Aurizon Holdings, the rail freight company floated by the Queensland government at $2.55 a share four years ago. It reached record highs this year above $5 a share.

On the other hand, there have also been some high-profile disasters. One of them was department store retailer Myer Holdings, which was offered five years ago at $4.10 a share, sank on debut and has never recovered that price since. It was recently trading around $1.79.

Many more Australian investors were burnt by the second instalment of the federal government’s sale of Telstra, what became known as “T2”. In that case, investors paid $7.40 a share across two instalments, but waited more than a decade before they could sell without making a loss.

The academic evidence around IPO performance is mixed, depending on time periods and other factors. But it’s plain that there is a lot of uncertainty around individual issues and it really is a crapshoot whether the stock does well or not after the offering.

By the way, none of this implies that Medibank or any of the other recent high-profile floats won’t be good long-term investments. It just suggests that there is often a lot of “noise” around the IPO process that makes it hard to get a good lock on a company’s underlying market value.

What’s the right approach? Firstly, it’s wise not to get overly fixated on individual stocks in building an investment portfolio. The most important influence on returns is your portfolio structure and how much you are allocated to the broader dimensions of return.

In pondering investing in IPOs, the assumption many people make is whether they can make a quick “stag” profit, which means capitalising on a short-term spike in the stock after listing. This is the equivalent of people buying apartments off the plan and “flipping” them.

That approach is more about speculation than investment. It’s akin to taking a punt on a horse. You might get lucky. Or you might not. The point is it’s not a systematic way to invest.

For its part, Dimensional’s approach with IPOs is to exclude recent offerings from its equity strategies, in most cases for a minimum of 12 months. The reasons for doing so we listed above—because of the lock-up periods and post-offering activities. We want to wait to see the prices reflect as much as possible the expected risk and return characteristics of the company.

As we have seen, the danger for many people around IPOs is they get caught up in all the publicity and media hype and feel compelled to buy in at the start. The alternative approach is to wait and see.

Ultimately, though, these decisions around IPOs are best left to an individual advisor aware of each client’s risk preferences, goals and investment horizons.