Angelica Montagano

March 4, 2021

Advanced Topics, Expected Returns, EMH, Historical Data

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

Angelica Montagano

March 4, 2021

Advanced Topics, Expected Returns, EMH, Historical Data

Since 1996, Jay R. Ritter has served as the Joseph B. Cordell Eminent Scholar in the Department of Finance at the University of Florida's Warrington College of Business. Prof Ritter is known as “Mr. IPO” for his work on initial public offerings. During 2014-15, he served as president of the Financial Management Association. Prof. Ritter has been a trustee of a mutual fund, and a consultant for companies on valuation and financing decisions. He has also worked as an expert witness for government agencies and law firms, and is frequently quoted in the financial press.

He is a frequent keynote speaker at academic and practitioner conferences around the globe. Prof. Ritter received his BA, MA, and PhD (1981) degrees in economics and finance from the University of Chicago, where he studied under eight Nobel Prize-winners.

We’ve previously compared IPOs to lotteries that are prone to inflated valuations and low returns. Today we welcome “Mr. IPO,” Professor Jay Ritter onto the show for a deeper dive into IPO performance, for his insights into SPACs, and to hear his research into why economic growth doesn’t correlate with stock returns. Early in the episode, Jay unpacks how long-term IPO returns perform against first-day trading. While exploring the role that venture capital plays in tech IPOs, Jay talks about why negative earnings don’t affect tech IPOs in the short-term before sharing how skewness factors tend to impact young companies. Reflecting on how IPOs are usually underpriced, Jay discusses how the interests of companies are not aligned with the interests of IPO underwriters. After looking into IPO allocation, Jay compares the 2020 ‘hot IPO market’ with the internet bubble of the late 90s. Later, we ask Jay about what special-purpose acquisition companies (SPACs) are and why they’ve exploded in recent years. His answers highlight their investing benefits, risks, and why SPACs might be a better option for companies than IPOs. We examine how SPACs have historically performed and then jump into our next topic; why economic growth isn’t a good indicator that a country is worth investing in. He touches on why returns don’t correlate with economic growth, the place of capital gains and dividend yields when investing abroad, and how innovations in an industry can lead to higher stock returns. We wrap up our conversation by asking Jay for his take on whether the stock market is efficient before hearing how he defines success in his life. Tune in to hear our incredible and informative talk with Jay Ritter.

Key Points From This Episode:

Introducing today’s guest, finance professor Jay Ritter. [0:00:03]
How long-run returns of IPOs perform against the first trading day. [0:03:06]
Industry differences in IPO returns and how venture capital affects tech IPOs. [0:03:33]
Why it’s not always a bad idea to invest in IPOs. [0:05:22]
Whether negative earnings for tech companies affect IPO performance. [0:07:32]
Exploring the idea of skewness in IPO valuations and returns. [0:08:56]
Jay shares advice on investing in IPOs. [0:11:07]
Why IPOs tend to be underpriced. [0:12:44]
Whether individuals get IPO allocations compared with hedge funds and brokerages. [0:18:00]
The factors that lead to ‘hot IPO markets.’ [0:20:53]
How technical innovation is linked to an increase in IPOs. [0:23:32]
Whether hot IPO markets tell us anything about future expected returns. [0:26:33]
Why 2020 was a hot IPO market and how it compares with the late 90s. [0:28:19]
The dubious value of individual investors getting exposure in the private market. [0:30:50]
Jay unpacks what special purpose acquisition companies (SPACs) are. [0:33:51]
How new SPAC prices are rising despite not having acquired an operating company. [0:37:11]
Ways that promoters benefit from launching SPACs. [0:38:34]
Whether SPACs are a better route for going public than traditional IPOs. [0:42:44]
We talk about the risks and historical performance of SPAC investing. [0:44:06]
Jay details the upsides and downsides of investing in SPACs. [0:48:02]
Insights into which foreign countries have been the best to invest in. [0:50:11]
How industry growth can lead to higher returns in that industry. [0:56:30]
What Jay uses to work out expected stock returns. [0:59:58]
We ask Jay the big question; “Is the stock market efficient?” [01:04:29]
Hear how Jay defines success in his life. [01:05:57]

Read The Transcript:

Professor Ritter, what do we know about the long run returns of IPOs measured at the close of the first trading day?

In both the US and Canada on average they underperform over the next year or three years, but unfortunately it tends to be that the tiniest companies have the under performance, the bigger companies, on average, neither outperform nor underperform.

Are those returns different across different industries, is there any sort of correlation there?

Well for any given time period some industries are going to do better than others. For instance, in recent years the energy sector has done very poor. Historically, however tech stocks have done very well, and not only for recent IPOs but for the tech sector in general. 40 years ago, I don't think any of us knew just how big and important in the economy the tech sector would be and indeed 41 years ago as we speak, the energy sector was pretty much at its all time high in terms of the proportion of market cap around the world. Over the last 40 years the energy sector has underperformed relative to the tech sector.

Interesting now venture capital tends to play a pretty large role in technology companies, are IPO returns different for venture backed and non venture backed IPOs?

That has varied over time. In the 80s and 90s that was the case, since then it has not been the case. But on the other hand, the last 20 years should have been very few tech IPOs that have not been venture capital backed. Back in the 1980s and 90s, there were a fair number of small startups that went public that not have professional financial sponsors. That's been increasingly rare where kind of the method for building a company has been kind of institutionalized where it's incredibly rare now for any startup that has a plan to get big to not bring in both the capital and the advice that venture capitalist bring in.

This is fascinating. So, I mean, so far we've talked about IPO returns on average not being so good. But if you split it up by company size, if you split it out by industry, it's not obvious that it's, you can't make a blanket statement that investing in IPOs is a bad idea. Is that correct?

Correct. The one thing that is worth looking at however is valuations. For instance, in the internet bubble, a lot of tech companies went public that crashed and burned. The valuations were just so high that it was difficult for public market investors to earn a decent return and a point forward basis. The last couple of years, people have been raising that same concern. In particular, in the last 12 months the average or the median price to sales ratio of tech companies has been almost as high as during the internet bubble. Historically, the average price to sales ratio of tech companies going public in the US has been about six.

In 2018 and 2019 that ratio almost doubled to about 12. The last 12 months it's been about 24. So, when investors are buying in at a multiple that already reflects very optimistic expectations the upside potential is more limited and the downside potential is greater. The company has to meet those very optimistic expectations in order to deliver. But there's a reason that investors are willing to pay the higher multiples, partly tech stocks have done very well. And I also think that the market doesn't view, every tech stock as the same. Some have more defensible niches with a moat. There are network effects for some and others are in more competitive industries where it's difficult for the company to grow and have high profit margins without competition eroding those profit margins.

What about companies with negative earnings? Again when we think about tech so many companies go public, that aren't generating a profit. Does that have a relationship with IPO performance?

For tech stocks there hasn't been a very strong relationship between pre IPO profitability and subsequent performance. But the market is definitely focusing on growth, and in spite of what you hear all the time about the market being so focused on quarterly earnings per share, when you look at young companies the market is telling them, don't focus on the short term, focus on growth, gain market share, develop your business and don't worry about short term profitability. That said, at some point the company does have to become profitable and it varies by industry. In the restaurant business the market is saying, if you're not profitable now, when are you going to be? The restaurant business is an incredibly competitive business where there are network effects competition comes, in another hand with tech stocks Facebook, Alphabet, Shopify, et cetera, there are those moats. I bet the market is correctly saying, don't worry about short term profitability, gain that dominant market share and the profits will come later.

What about skewness, I mean, we're talking about the market giving high valuations to these companies and the companies you just mentioned, they've sort of come out as a winner take all type companies, there must be a lot of other companies that had high valuations that didn't do so well. Do we see skewness in IPO returns?

Absolutely. And in general, the younger the company the greater is that skewness, the higher the failure rate, but the possibility of big upside success. This is most extreme for venture capital investing in startups and it's not unique to venture capital in the stock market. Book publishers, songwriters, movie producers realize that the most likely outcome is failure for any song or movie or book, but occasionally there's a blockbuster. They're counting on that skew as venture capitalists realize that the vast majority of startups they invest in are going to result in write offs.

But every once in a while a Facebook or a Shopify comes along where the early stage investors earn enormous returns before the venture capital investors, the limited partners an extreme example is at the start of the internet bubble in 98 and 1999, what at the time were the two most prominent venture capital firms Kleiner Perkins and Sequoia Capital in Silicon Valley raised $500 million funds. And they invested most of that money in private companies at the peak of the internet bubble and almost all of them wound up as write offs. But they each put 25 million of that $500 million fund in a startup search engine called Google, that one investment produced such high returns that the limited partners made many multiples of their investment even though 95% of the money basically got wasted.

That is such an interesting story. With consideration for the students do you think investors looking at IPOs and getting excited about investing in them on an individual basis, people should probably exercise quite a bit of caution?

Don't put all your eggs in one basket, it applies to all stocks, including IPOs. In Canada, the TSX Venture Exchange is had a similar experience to a lot of other exchanges around the world aimed at young companies helping them raise capital, where the vast majority wind up being failures, occasionally there's a big success. But to the really tiny companies on average, public market investors wind up disappointed. Not only the majority of the time but on average, that investors seem to be buying lottery ticket where just as with lottery tickets the middleman takes a cut and on average as an investment it produces a very low perhaps negative return. That seems to be the pattern pretty much around the world. If we think about a lot of the tech companies and other companies that have gone on to great success after being public companies, typically they did not go public at a real early stage. They had already demonstrated that they've got a product or service that consumers are willing to pay for. Many times they weren't profitable yet, but they did demonstrate that it was more than just a business concept.

So IPOs on average pop in price on the first day of trading. I guess indicating that the issue was under priced, why do IPOs so systematically get under priced like that?

Well this is a pattern that exists around the world. On average, the market price once the stock starts trading is about the offer price, it doesn't happen all the time. There are companies that sometimes drop on the first day of trading typically only a little bit. And then there's some that jump ally, the vast majority go up just a little bit on the first day of trading. And this is especially true in Canada for TSX offerings, where Canada actually has less extreme underpricing than in most countries around the world. Basically the IPO market in that respect works better in Canada than it does in the US. In the last year in the US, there's been a lot of extreme underpricing. The average first day return has been about 40%, which is the highest level since the internet bubble.

A lot of companies have shot up. As we speak, yesterday Bumble went public and went up about 70% on the first day of trading. The company could have raised a lot more money if they had been able to sell shares at a price closer to that market price than the offer price that investment bankers had recommended. In general, underwriters initial firms realize that to get investors interested, they have to underprice the stock by a little bit. But that doesn't explain why some companies are under priced as dramatically as they are. I think partly what goes on is for a minority of companies, investor demand is really strong and the underwriters take advantage of that, they know that the issuing company is going to be happy with the pleasant surprise, and they don't raise the offer price as much as they could, the issuing company is still happy. It was a successful IPO, they raised money, maybe raised more money than they could have or were expecting to.

The paper wealth of the employees and founders and financial backers is higher than they expected it to be. But the underwriters don't have the same incentives that the owners of the company have. The owners of the company benefit from a higher offer price, the underwriters benefit from a lower offer price. With most IPOs in the US and Canada, a procedure known as book building is used, where the underwriters ask institutional investors, what price are you willing to pay? How many shares do you want? And they find out about demand before they set the offer price. But if they find out that there's really strong demand, they don't raise the offer price as much as they could. There's then excess demand and the underwriters are allowed to hand out shares to their preferred clients.

Well, who are the preferred clients? The most profitable clients. How do you get to be a profitable clients Well you overpay on other transactions. And so the underwriters have this incentive if they underpriced the deal, they induce their institutional investors including hedge funds to overpay on other transactions, which boosts the profits of the underwriters. It doesn't help the issuing company, but it does help the underwriters and that's where their interests are not aligned, where there's a conflict of interest between what's best for the underwriter and what's best for the issuing company.

Wow. Has the underpricing effect been constant over time or is it changed?

The underpricing has not been consistent over time. In the internet bubble it was extreme in the last year in the US, it's been extreme. And these periods correspond to rising stock markets, they correspond to periods where the company might have formed its expectations about valuation and what offer price to expect at an early stage in the process. And then as the market has gone up and especially if the market has gone up for that sector, and that company, the issuing company and their shareholders are happy at the good work being there during a rising market because they're happy. They typically don't get upset if the underwriter leaves more money on the table than was necessary.

That's unreal. It's like a psychological arbitrage that the underwriter is taking advantage of is what it sounds like.

I agree. In fact, Tim Walker and longtime co-author of The Blind and I published a paper almost 20 years ago, where we focused on the psychology of what goes on with the founders of the company, and how they're happy to have a high paper wealth even if the paper wealth could have been even higher.

Unreal. So do individuals get much of an allocation to IPOs or do most of the IPOs go to hedge funds and other very large clients, the brokerages?

It varies with TSX Venture and very tiny offerings. Typically they're distributed mainly to individual investors. For the bigger offerings however, it's mainly allocated to institutional investors. As a rule of thumb in the United States, 90% of the shares in an IPO go to institutional investors, mutual funds, and hedge funds. In Canada, some of the big pension funds might get a little higher proportion.

And as an individual to get an allocation I assume you have to be a client of the underwriting broker, correct?

In general, yes, you have to be a profitable client in many cases. However, there's an additional danger. Sometimes the institutional demand is not real strong and more shares are therefore available for allocation to retail investors. This happened when Facebook went public almost a decade ago. It was expected to be a hot offering, but institutional investors were getting concerned about whether Facebook would be able to monetize mobile users. As it turns out, Facebook has been able to do that, but it wasn't clear at the time. And they started getting hesitant about buying the shares, but there was very strong retail demand. And rather than 10% of the shares going to retail investors 25% went to retail investors, one of those retail investors was me. I haven't bought all that many IPOs over the year, but I did ask with my discount brokerage account for shares in the Facebook offering.

And I asked for 5000 shares and I was expecting to get 100. I got an email that morning saying I got 300. And I told my wife at breakfast, I'm not sure this is good news. It's good news that we got more shares than I was expecting but maybe this is bad news in that it might reflect a lack of institutional demand. As it turned out, that was exactly the case. And during the next six months the stock price fell by about 50%. Unfortunately I sold for tax loss reasons and didn't hold on, where Facebook has been and gone on to great success.

Fascinating, so there's adverse selection. If you as an individual can get access to an IPO allocation, it's probably not a good one.

There is a very big danger there, is kind of the Groucho Marx theorem, any club that's willing to accept me as a member is a club that I probably don't want to join.

You mentioned a couple instances of lots of IPOs happening and massive underpricing like we mentioned 2000, 2020, it looks like it was similar. Do we know what causes these hot IPO markets?

There're variety of issues but actually, let me go back for a moment about the allocation to individuals. It's definitely an adverse selection problem but if you do have a full service brokerage account, if you're a profitable customer, you might be one of those investors who does get favorable allocations. If you've got a discount brokerage account, if you're paying nothing for commissions, then you've got to worry about adverse selection. If you are paying a broker for more hand holding you might not have to worry about this as much. Moving back to the question that you just asked about changes over time, some periods there is very high underpricing of a lot of deals. In the last 12 months in the United States, there have been a lot of deals that have jumped in price. It continues to surprise me how long this has gone on, many of them have been hot tech deals, but some of them have been in the healthcare sector. In particular with biopharmaceutical companies where there's been a huge boom in that sector, part of it has to do with the COVID-19 situation.

This is the ninth year in a row where the biopharmaceutical sector has been having a lot of companies going public, that sector has been doing quite well. Partly because there have been some scientific breakthroughs. The old trial and error method of developing new drugs has been getting more efficient and capital has been flowing into the industry, partly with venture capital funds investing and partly with many of the companies then going public and investors know that not only are most of these companies losing money most of them have no revenue and no prospect of revenue from product sales from many years ahead. In fact, investors know that most of them will never have a successful drug, but occasionally there will be a company where the science works out and they will have a blockbuster drug. In many cases, they will then sell out to a big pharmaceutical company at a premium price. So investors are counting on skewness in the market for the biopharmaceutical companies.

Interesting. So do you think these IPO waves are related to technological advances? We're seeing all these tech IPOs and you're mentioning BioPharm, is that the causal relationship?

There's definitely a relationship between the underlying technology and the stock market. If we go back hundreds of years Adam Smith's invisible hand theorem had capital flowing to its highest value used. There are some industries that are advancing where capital is flowing in electric vehicles, autonomous vehicles are definitely sectors where there's advances going on and investors are very excited about that. In the internet bubble, the internet was jumping ahead, investors were very excited about it. What sometimes happens though is the valuations get ahead of the technology. What we find, not just in the IPO market, but there's a danger of investors chasing past returns. We saw this with the housing bubble, where in Spain, in Iceland, in the US, not so much in Canada, investors in the early 2000s were making a lot of money as real estate prices went up and people then poured money into real estate, pushing the prices up even further.

And the prices got too high, and the bubble burst. In the internet bubble that's what happened. Right now, with autonomous vehicles, electric vehicles, it's definitely an exciting area, strong advances are being made in the technology. Everybody agrees that this is the future. Legacy auto companies, General Motors, Ford, Toyota, Volkswagen, they all agree that this is the future and that radical change is going on, but what's the right price? I should acknowledge I am short in Tesla. So far it's been money losing for me, a little over two years ago I bought a Tesla Model S. I've been kind of disappointed, the autopilot doesn't work as well as I had expected it to, the improvements are slower than I had expected.

I get these online updates, most of the time or adding a new video game that I can play while the car is in park. The autopilot hasn't been improving very much, so the change is occurring less quickly than I had expected it would. There's definitely improvements being made. Cars are getting safer and electric vehicle technology battery, technology is getting better, but there's a price at which it's a fair price where the expected returns and a point forward basis are consistent with the market. And there's a price at which the price has gotten too high and expected returns are going to be lower.

So that leads perfectly to my next question, do hot IPO markets tell us anything about expected returns going forward?

Yes, on average the hot markets have been followed by lower returns, but as with all things, whether it's real estate, whether it's the fixed income market bonds, whether it's with stocks, calling the turning points is always difficult. In recent years, interest rates have dropped and continued to drop. And that has surprised just about everybody how low interest rates have gotten worldwide in both real terms and nominal terms. Is it going to go on forever, the continued drops? No, but where's the turning point going to be? None of us know. The same with the stock market and electric vehicles. With Tesla, I thought the stock was overvalued before it went up another 800%. And I wish I had been better on that market timing.

I heard you on a podcast in 2019, where you talked about your short position in Tesla so I was wondering if you still had it.

Actually in March of this year when the stock market had dropped I did cover a little bit of the position, but then I have added to it since then, in particular in December when Tesla was added to the S&P 500, and it jumped dramatically. At the close on the day that it was added I shorted additional shares. I was making the market more efficient, there was this demand from indexers, I was a supplier by shorting more shares. I thought that was likely to be the peak. So far I've been wrong, once again.

Would you say, we talked a little bit about the underpricing in 2020, would you say 2020 was a hot IPO market?

Yes, the average underpricing was quite high, the volume of deals after falling off in the spring, when the stock market around the world tanked. But nobody expected right stock markets would come roaring back as much as they have, especially the tech sector. China and the US has had some of the biggest recoveries, especially in technology. A lot of biotech and tech companies and other companies have taken advantage of that by tapping public markets. The start of 2021, we're seeing very high levels of activity that we haven't seen since the internet bubble.

You mentioned that comparison. Anecdotally this period feels the most like the late 90s or early 2000s to me, just in terms of dealing with retail clients, how do you compare this period to that period?

Well, there's a lot of investor enthusiasm, but one big difference between now and the internet bubble is in the internet bubble lots of startup, very young companies were going public. Back then, the word was first mover advantage. They were all fighting to be the dominant player in some niche, with the idea that there would be a winner take all situation. That's still the case in a lot of markets, but the big difference now is we're not seeing young startups going public. It's mainly companies that have been nurtured by venture capitalists for many years, where it demonstrated, yeah, we've got a product that consumers, whether it's individuals or businesses find worthwhile.

And so the chance that the company is going to fail is dramatically lower because we've got more mature older companies going public. On the other hand, they're going public at very high valuations. The sales are higher, but the price to sales ratios are also very high. And so these companies are more likely to be winners, or in many cases, they'll eventually merge with some other company in the industry. But they probably won't be merging at fire sale prices, but on the other hand when you go public at a $10 billion valuation the upside potential is more limited than if you had gone public at $100 million valuation.

That raises another interesting question which is that companies are going public later. We know that, kind of like what you're just describing, fewer companies are going public than they have in the past and there are fewer listed companies available in the stock market now. Do you think investors should be looking at getting exposure to private markets based on that?

The simple answer is, no. Private markets aren't great for individual investors. So we talked about adverse selection before. For individual investors, even if you're wealthy, getting into a venture capital fund or a private equity fund, that's going to be able to find the Shopify or Google or Facebook is difficult. It's difficult for the VCs to know which companies are going to be successful. But while we've seen some big successes for some of these venture capital backed companies, we don't read so much about all of the failures. So it's important to look at averages. There's a study by Ludovic Phalippou of the University of Oxford's business school that attracted a lot of attention this past year where he calculated that since 2006, 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. Indeed he emphasized that the general partners have gotten rich, whereas the average limited partner has done as well as if they had invested in publicly traded stocks. So I don't think it's the situation that individual investors are losing out on a great opportunity. It's also the case that most of the investors in these private funds are not individuals, their pension funds endowments, those are the main institutional investors. And so individuals are getting the benefits indirectly through those investments. I don't think there's any great missed opportunity for individuals. Of course some funds are going to do really well, but others will be disappointing. But also if we think about what we'd expect to see.

This isn't a surprise that the limited partners haven't been earning abnormally high returns. If this sector was offering great opportunities, more money would flow into it, and that extra money would push up the prices that the VCs and the private equity firms have to pay, lowering the returns that their investors are going to get. And I think that's exactly what's going on. So much money has poured in that it's difficult for them to find a company and buy into it at a really low valuation.

So another topic that is getting a ton of attention lately are these SPAC, special purpose acquisition companies or blank check companies. So we have a bunch of questions on them but to kick it off, can you describe what a SPAC is?

A SPAC is a company that is modeled after Canada's capital pool companies where they conduct an IPO, raise cash, and that money is put into an escrow fund. So the middleman, the founders of the SPAC are known as the sponsor. They don't get that money instead it goes to a third party with a money back guarantee for those investors. And then the SPAC sponsor goes out and typically they've got an 18 month or a two year horizon, which is specified in the IPO contract, where they have to find a company, almost always a private company to merge with. And importantly the public market shareholders have to vote to approve the merger. If they don't, the investors have the right to get their money back with interest. And so, the downside risk for the SPAC investors is non existent, but there's upside potential. The typical SPAC sells a unit that is composed of a share, plus a warrant to buy another fraction of a share, and the share portion of that unit has this money back guarantee.

And so essentially the SPAC IPO investors are getting a free warrant. This is a great deal for the SPAC IPO investors. Now, how valuable that warrant will be depends upon is the SPAC able to find a good company to merge with and negotiate deal terms that make it favorable for the SPAC investors. Until two years ago, or a little over a year ago, the SPAC market was not all that big, typical year, maybe 50 stocks, went public, raised maybe $5 billion, maybe a little bit more. But last year, the stock market exploded 248 SPACs went public in the US, raising about $80 billion. And this year, that explosion has gotten even bigger. We're seeing so far this year, over 20 SPACs per week, going public. In annualized pace of 1000 and raising more and more money and the SPAC prices are jumping on the first day of trading and going up in many cases beyond that.

And in many cases we'll have mergers and now it's jumping even more. There is a danger that so much money is there now chasing the operating companies to do a merger, that the operating companies are in a great bargaining position. If they've got five SPACs that are going to do a merger with them, they can play them off against each other, and the operating company might find this is a better way for us to go public. If the merger occurs, this private company will now be a public company, having merged with the publicly traded SPAC.

So a SPAC price can go up once it goes public even though it doesn't own an operating company yet?

Yes, indeed what's been happening this year, and starting at the beginning of last year, is on the first day of trading the price has been jumping. Every single SPAC that has gone public since November has gone up in price on the first day of trading, like, 180 out of 180. Some of them have only gone up by a tiny bit. Others have gone up by 10, or even 15% on the first day of trading. For investors, mainly hedge funds that buy at the offer price they no longer have to wait if they're willing to sell the unit right away, they can pocket that first day return. Now it's not as big on averages for operating companies. This year for SPACs the average first jump has been 6%, whereas it's been 35% for operating companies. But if you're an ordinary investor like me, you can buy in once it is started to trade at, on average, $10.60 per share, they almost always go public at 10. There's still upside potential although now, potentially I could lose 60 cents. But, on average, they have continued to go up in the market after that.

What's in it for the promoter to launch a SPAC?

The SPAC promoter, typically keeps 20% of the shares. So, the SPAC is selling 80% to the public, and that money goes into an escrow account, and the SPAC keeps, the SPAC promoters, keep 20% of the shares for free. So they're getting 20% of the company for free. It's actually a little more complicated than that. They typically buy warrants at the time of the IPO, where they're typically paying five or $10 million for that. So they are putting in five or $10 million with their own money into the company, if they don't find a successful merger partner they lose all of that.

And on the other hand if they do find a successful merger partner, and the shareholders approved and it does well, it can be very lucrative to the SPAC. But of this five or $10 million they're putting in part of that goes to pay the expenses of finding an operating company to merge with. And part of it goes to pay some of the investment banking fees. So, when the SPAC goes public at 10 underwriters typically take 2% upfront as a fee. So there's only $9.80 per share, but the sponsor typically tops that up by putting in an extra 20 cents out of their own pocket so that the investors that put in $10 are going to get $10 plus interest. There's no downside risk at all for them, and in return then the sponsor has some money at risk. They've also got the upside potential so they've got good incentives to try and find a successful merger partner. And some of the, just as with other mergers between one operating company and another, some of them then work out, others don't.

But you're really relying on the promoter to find a great operating company because if it goes public, correct me if I'm wrong, let's say $10 the price goes up to $12 and that promoter gets 20% warrants, there's a lot of dilution that's going on there is they have to get a very good company to justify the valuations. Am I accurate in that?

Yes, there is that dilution cost, the public market investors are putting in 10, but the SPAC then only has $8 in cash per share, because only 80% of the stock was sold. So, the SPAC sponsor does have to find a merger partner and negotiate a deal that's attractive enough to cover that 20% dilution. And sometimes the SPAC sponsor then puts in additional cash buying additional shares at $10 each typically that's done at the time of the merger. Sometimes they also find another investor to invest at the time of the merger putting in additional cash, that's typically called a pipe investor, private investor in public equity. So this fact might raise $200 million. At the time of the merger they might get another 100 million dollars put in, and instead they've actually got $300 million to give the operating company. And it's just as if the operating company had gone public and raised $300 million in the merger.

Now, the operating company in deciding who to merge with they frequently do pay attention to, just like companies looking for venture capital funding look at, well, who are these people? Do they have industry expertise? Can they offer advice that's going to make us a more valuable company? And so, a SPAC that has sponsors, that have been successful executives in a given industry, generally, has more success at finding a good merger partner and negotiating a good deal, because in addition to offering cash they can offer quality advice to the company as well.

There's a bit of a narrative out there, probably maybe coming from SPAC promoters that SPACs are sort of a cure to high IPO costs and the underpricing issue that we've talked about. Are SPACs a better route for going public than the traditional route?

The simple answer is maybe. We see lots of operating companies going public, we also see lots of SPAC IPOs, and we see mergers from SPACs the last two years occurring. So it looks like there's not a one size fits all, that all of these things are going on and at the same time there are also some companies doing direct listings, where they bypass traditional IPOs and stack mergers and list their shares directly on the stock market bypassing those middlemen. So with both traditional IPOs where money left on the table causes dilution to the pre IPO shareholders, with a SPAC, both for the IPO investors and for the operating company there's dilution due to the SPAC sponsor shares. And in any given deal the costs and benefits might be higher, with the traditional IPO, that with the SPAC merger or vice versa. It doesn't seem that one size fits all.

Are there any unique risks people should be aware of the SPACs?

Well, for the IPO investor or buying before a merger has been announced, you do have to pay attention to that announcement. There is a danger if other investors don't think the merger is all that great that they asked for their money back, and the SPAC has a problem. We don't have the money to complete the merger. And if you're not paying attention and don't ask for your money back you might be left holding shares that are worth less than $10. And so it is something that you have to pay attention to. And if you're buying in the market at $10.60 or $11 or $12, there is the possibility that you're going to lose if a merger occurs, but the stock price winds up being only worth $10.10, and you bought at 12, you've lost that.

And furthermore, after the merger occurs sometimes the deal doesn't work out, and the stock price might decline to $1 a share, and you've lost 90% or more. On the other hand, maybe you were lucky enough and your SPAC invested in DraftKings, and the price has gone up twofold, threefold, fourfold, and you've made hundreds of percent on your investment.

It sounds like we're in a bit of a different stock market, just with the volume. But if we look at the historical data, how have SPACs performed historically for investors?

Historically for the IPO investors, it's been a great deal. If you bought at the IPO or in the market at a tiny premium and held it until a merger was completed, or you got your money back, on average, investors have earned 9.3%, per year, with no downside risk. The worst deal, still produced a positive return because of the interest earned on that escrow account. 9.3% on a risk free investment is pretty great. But for the post merger period sometimes called the de-SPAC period, because it's no longer a SPAC, now it's just a company that's publicly traded, on average in the past, deals have underperformed the market. But we have to be a little careful with that in that recently the average deal has done very well. And also, historically, if at the time of the merger announcement investors haven't been very enthusiastic, most investors have redeemed.

And those are the deals that typically have done worse. And since most investors redeemed there weren't many investors left who lost money. So if weigh it by how much cash was there, the returns haven't been great, but they've been better than if we ignore the fact that the good deals investors leave their money in and the bad deals they take their money out. But, as I mentioned, in recent months, things have been great. So, using that historical average when there weren't all that many deals, the numbers look worse than if we take into account what's happened recently. But you'll have the recent good performances been because there's a bubble going on, which won't continue in the future, that remains to be seen. I do have concerns with so many SPACs going public and so many SPACs chasing deals that they're going to be in a situation where it's harder and harder to find a good deal. On a point forward basis, some of the deals will do well, others won't. I'm not sure what the average is going to be.

You mentioned the 9% effectively risk free investment for historical IPO stock investors. Do you think that's going to be different, going forward, just because of the amount of SPACs and the pricing?

Well, historically, it didn't jump on the first day of trading so even a retail investor like me could buy in at just tiny bit above $10. And so my returns could be as good as for the hedge funds. Indeed, I wish I had started doing this earlier, but last year I started buying SPACs right after they went public, and they've done very well for me in recent months. But now that the prices typically jump on the first day of trading, I've stopped buying. I think that there's still some upside potential, and they're still relatively good deals compared with just having your money in the bank, but the free lunch isn't as big as it had been. It's also the case that while on average recently they've been jumping up 6% in the first day of trading some go up one or 2% others go up, 10 or 15%.

Partly that difference is based upon the quality of the management team that the sponsor has and partly it's based upon the details of the SPAC unit itself. Some of the units offer a share plus award to buy a full share. Others offer a share plus no warrants at all, or a warrant by one eighth of a share. Well, a warrant to buy one eighth of a share isn't worth as much as a warrant to buy a full share or a half share. And so, paying attention to the quality of the management team and paying attention to how much the warrant is giving you also matters.

That just made me think of, I've seen some SPACs ETFs where you can just participate in all of the SPACs effectively look with an index fund like approach, but based on what you're saying about needing to pay attention, that sounds like it might not be the best idea.

Well, the SPAC ETFs including Josef Schuster's SPAC ETF have done incredibly well in recent months. But as we talked about before chasing past returns can sometimes not work out too well for investors. Nobody expects the returns in the future to be on average as high as they have been the last couple of months. For one thing, the stock market has gone up. Secondly, there's been this increased enthusiasm for stocks, a number of the merger deals have been very attractive. I think there is a danger of chasing those past returns, but it's entirely conceivable that in the next couple of months the SPAC ETFs will continue to do very well.

So I think we can move on from SPACs, it's so fascinating. So one of the questions I've been most looking forward to asking you has to do with countries that have high economic growth, and many people assume that's the best place to invest, based on that expected growth. Is that necessarily true from the data?

This is shifting off the topic of IPOs but, I have published some articles over the years that look at the long term returns in different countries, the average return in Canada, versus the average return in Brazil and the economic growth rate in the country and in particular focusing on per capita, economic growth. This analysis is based upon work that was first done by Dimson Marsh Staunton at the time London Business School professors who published a book, 20 years ago about the previous centuries return, where they found around the world, surprisingly, that there was, if anything, a negative relation between a country's long term per capita inflation adjusted economic growth and inflation adjusted stock returns. That the countries with the best economic growth per capita didn't necessarily have the best stock returns. In particular, something that nobody guesses at in terms of stock markets that existed 120 years ago, what would have been the best country to invest in? And I'll pause for a second to let everybody think about the country that they think would have been the best to invest in.

None of you would have guessed, South Africa. South Africa is not a rich country today, it's not the poorest of the poor, but it actually has been over the last 120 years, the best country to have invested in publicly traded stocks, even though the standards of living have increased by fairly modest amounts compared with some other places. China has certainly had a huge economic growth over the last 31 years since their stock market reopened. But, China has not been the best emerging market to invest in. Indeed over 120 years, the best markets to have been invested in have been South Africa, Canada, the US, Sweden, Australia, these have a few things in common. One is almost all of them are English speaking countries that have British legal systems as kind of the dominant legal system. They've all been fortunate to not having had a war fought on their territory during that time, but in particular, when we look around the world Japan was a really poor country 120 years ago. It's a rich country today, but it hasn't been the best place to invest for stocks. The last 31 years since the bubble burst at the very end of 1989 in Japan, Japanese equities have produced negative returns, China has produced lower returns than Mexico over the last 20 or 30 years, even though Mexico's per capita growth rate has been actually even among emerging markets fairly low, in China has obviously been very high.

So what explains this lack of relation between economic growth and stock returns? Well, partly, you have to pay attention to the price earnings ratios. South Africa historically has had fairly low price earnings ratios, and it's also had high dividend yields. We tend to forget this and that the last couple of years, last couple of decades, capital gains have been more important for dividend yields but historically high dividend yields have produced high returns. I don't think that's been eliminated. If a company doesn't produce profits its stock isn't going to do well in the long run. What produces profits? Well, a country's profits can grow without a company's profits growing. When you're investing in the stock market, you're investing in the company's per share profit growth, and China is an example of a country where the stock market is growing by a lot. The economy is grown by a lot, but per share earnings, have not grown by a lot. China's stock market is mainly growing due to more companies going public without the stock prices of individual companies going up by a lot.

Now, there are some companies that have done well, Alibaba, Tencent, but actually Alibaba went public in the US. Tencent went public in Hong Kong, domestic investors in China weren't permitted to invest in those companies. The most valuable company in China is a liquor company, Maotai. I think nobody would have predicted 20 years ago that that would have been the best company to invest in China. But we see in many cases, a country is able to grow dramatically without the earnings per share of the incumbent companies growing by as much as the economy grows.

Do you think that relationship holds at the industry level if we have an industry that's going through enormous growth, like we talked about electric vehicles earlier that kind of thing where there's a big technological advancement. The industry is set to grow massively, does that lead to higher stock returns for the industry?

In many cases, yes, but importantly, getting in early, rather than buying in at the peak is important. And, on average people are buying in at the peak. With tech, a lot of the biggest market cap companies today, all of the biggest market cap companies today did not start out as the biggest. Whether we're looking at Shopify or Microsoft or Apple, Amazon, Alphabet, Facebook, most although not all of them went public when they were profitable and already pretty big companies. Amazon.com was an exception, they went public at a pretty early stage and took many, many years to become profitable, because they were focusing on growth for so many years. And today they make most of their money from the cloud, something that wasn't even in their thoughts when they went public in 1997. But for investors who are buying in today, it's difficult to know which are the industries that are going to be the dominant industries of tomorrow. Certainly tech will be big, but tech is already big.

And do you think that like you mentioned with the country level, if a country is growing a lot, the country's overall profits can grow but if that's happening through lots of new companies and the earnings per share is not growing, that can lead to poor stock returns. Could we see the same thing at the industry level?

It's indeed possible. If we go back to 1980, the energy industry was the biggest sector of market cap in the world. Oil prices have gone up tremendously in the previous decade. Alberto was a huge beneficiary of that, and people were projecting that oil prices would continue going up forever. Well, it hasn't worked out that way, with tech, maybe it's different because we do have some of these winner take all situations where some companies and can continue to achieve very big profit margins without competition eroding those margins. But that doesn't mean that the tech sector will continue to be growing market share. And how we define the tech sector has changed over time as well. In Canada, banks are a very big fraction of market cap.

Well, for many decades people in the banking industry have said, what is the banking industry? Well, they're IT companies that happen to be dealing with money, but Information Technology spending is a really important part of banks, that to prevent fraud, to make efficient decisions, to decide what interest rate, to charge and what the credit limit should be on credit cards, et cetera. There's an awful lot of technology there and yet there is the FinTech sector. But if we look at the IT spending a banks, it could also be classified as tech firms.

Professor Ritter, I want to finish off with a couple of questions stemming from a paper that you wrote, titled The Biggest Mistakes We Teach, where you kind of took a bunch of generally accepted ideas in finance and you basically rip them apart, which is something that I love. Similar to the paper that we just talked about with economic growth, versus stock returns that paper was hugely influential to me as I'm sure it was to many people. When investors are planning for the future what do you think they should use for unexpected future stock return or unexpected equity risk premium?

I'm a big fan of the Shiller price earnings ratio, the cyclically adjusted price earnings ratio cap, sometimes called the Shiller price earnings ratio. If we flip the price earnings ratio we get the earnings yield, earnings overprice and what Shiller has done is he uses the 10 year average earnings of the S&P 500 and divides it by the current level of the S&P. And he uses that 10 year average to adjust for business cycles, profits state might be higher or lower than average but over a 10 year average, it kind of averages out. And this is becoming increasingly popular for good reason as a measure of the expected real long run return on stocks at a point forward basis. And today that number is down to about 3%, the expected real return on stocks is only about 3%.

Now he's using US data but to the degree that investors have a choice about what market to invest in, those international capital flows would lead one to expect that the expected returns ought to be about the same everywhere. And so the expected return 10 stocks are not real hot in inflation adjusted terms, but the expected returns on all asset classes are low today because interest rates are so low. The inflation adjusted bond yield for 10 year bonds tips Treasury inflation protected securities is about, minus 100 basis points. So the difference between 3% expected return on stocks and the minus 1% expected return on risk free bonds is about 4%. That number has actually been amazingly constant over the last decade, and in the internet bubble inflation index bonds were yielding 4%, and the Shiller price earnings ratio was predicting a yield of about 3%.

So, that equity risk premium, the difference was minus 1%, stocks had expected returns lower than bonds. Which is one of the reasons why I was out of the market at that time, out of the stock market, but just like Shiller I got out a little too early, and when to get back in is always a question. But today, given that the expected returns on all assets, whether it's real estate, bonds, equities are low, while stock expected returns are low, I still think that having a diversified portfolio that includes all asset classes including stocks is a good idea for most investors.

I just want to touch on something that you mentioned there, like you said, when you look at the US cap the expected stock returns look very low but if you look at emerging markets or Canada or international developed, it doesn't look so bad. But you said that the expected returns are probably the same. Can you elaborate on that because that's a little bit mind blowing.

No, they're not going to be exactly the same, but investors who have a choice, especially if you live in countries like Canada or the US with the right restrictions on capital flows like China has, we can have a choice of how much to invest domestically, how much to invest internationally, how much to invest in a specific market. In the last decade, the US has had really high returns, but that doesn't mean that, that will be true in the future compared with other countries. I continue to remain internationally diversified over the last decade, there has been a drag on my portfolio returns, but on a point forward basis I'm fully comfortable being internationally diversified.

Interesting. Okay, I understand. All right. My last question before we get to our last last question. You're a Chicago graduate. And we've talked about a few things that you're doing in your investment accounts like shorting Tesla and investing in SPACs, so I have to ask, is the stock market efficient?

Yes and no. As one of my former professors Eugene Fama has said, all models are wrong, but some are useful. The efficient markets hypothesis can be a useful way of thinking about things, but that doesn't mean that it's perfectly correct. I wouldn't be shorting Tesla, if I thought that the stock market was completely efficient. During the internet bubble period I thought tech stocks were ridiculously overvalued. There was 100% certainty in my mind that a bubble was going on. And I was right. I didn't know when the turning point would be just like today, nobody knows where the turning points will be, but a problem for most individuals when they try and time the market is they do things exactly wrong. People tend to chase past returns, so they invest in real estate after real estate prices have gone up. They invest in tech stocks, after tech stocks have gone up. Maybe they'll continue to go up for a while. But, on average, chasing past returns has proven to be the wrong strategy. But that's the strategy that most investors follow.

A great answer. And I get the privilege of asking the last last question, which is often the least of my favorite. How do you define success in your life?

There's more than one way to define it. I don't view it as one size fits all, there's professional success, there's personal success, money isn't everything, health is probably the most important thing. One thing I would say though is looking back, or if you're younger looking forward, being able to think ahead and ask yourself, out of the people that I've interacted with in my job, in my personal life, family, friends, how many of them have walked away thinking, this person is a jerk? If you can rationally say, just about everybody considers me a nice person. I would view that as a big measure of success that's under your control.