Here's a fun fact that may surprise you: During the Great Depression, the general partners at Goldman Sachs (GS) would often reimburse investors' losses if they believed that they were responsible for misguiding an investor on a particular transaction. When Sidney Weinberg ran Goldman, he knew that reputation was everything, and he considered it a moral obligation to find the right initial price offering for companies so that both the new and existing owners could get a fair deal. Career-wise, his high water mark came when he perfectly judged the $350 million price for a debt offering of Sears-Roebuck (SHLD) debentures in 1958.
Fast forwarding to the present day, it doesn't take a degree in geothermal engineering to know that confidence in IPO underwriters is woefully abysmal. Joe Nocera of the The New York Times wrote an excellent article today outlining the ethical failures at Goldman Sachs during the tech bubble craze of the late 1990s. Nocera points to the release of private documents concerning the eToys public offering in 1999 to demonstrate Goldman's alleged dishonesty in handling IPOs, treating the eToys public offering as a microcosm of everything wrong with the culture at Goldman:
The plaintiffs charge that Goldman Sachs had a fiduciary duty to maximize eToys' take from the I.P.O. Instead, Goldman purposely set an artificially low price, so that its real clients, the institutional investors clamoring for the stock, could pocket that first-day run-up. According to the suit, Goldman then demanded that some of those easy profits be kicked back to the firm. Part of their evidence for the calculated underpricing of eToys, according to the plaintiffs' complaint, was that Lawton Fitt, the Goldman executive who headed the underwriting team and was thus best positioned to gauge the market demand, actually made a bet with several of her colleagues that the price would hit $80 at the opening. (Through a Goldman Sachs spokesman, Fitt declined to comment. Goldman denies that it did anything wrong…)
But don't take my word for it. Look at the evidence and make up your own mind-if you click here, you will be taken to the part of The New York Times website that outlines the evidence against Goldman Sachs, with the particularly damning information highlighted in yellow.
Anytime curiosity strikes or I have the urge to consider investing in an IPO, I go straight to the blunt wisdom of the legendary Benjamin Graham on the topic. The late Columbia professor and mentor of Warren Buffett rarely spoke in absolutes. Yet, when he discussed initial public offerings, Mr. Graham gave unhedged, unequivocal advice: Stay away from them altogether. He gave three reasons why:
1. Very few initial public offerings trade at a discount. Think about Graham's overarching philosophy when it came to investing-Graham was all about finding overlooked, underappreciated, and most importantly, undervalued securities that were trading for much less than what they were worth. When a company is going public, the interest in the security is at an all-time high. The IPOs are the "shiny objects" of the investment world. In Graham's view, the inherent novelty of a newly traded security made it a fertile breeding ground for the kind of irrational euphoria that Graham famously warned about in his Mr. Market analogies.
2. Newly traded securities will likely fall hard at the first hint of bad news. Once the newness of a freshly issued stock begins to fade, investors will often flee at the first sign of trouble (even if the business itself happens to be excellent). To use Graham-era examples, Coca-Cola (KO) lost 50% of its share price within a year of its 1920 public offering because of supply troubles with the sugar refiners. Clorox (CLX) lost 35% of its value following its 1928 public offering when it had to slow its expansion due to sodium hypochlorite shortages that preceded the Great Depression. IBM (IBM) lost 75% of its value between its 1916 public offering price and its low price in 1932, even though earnings more than sextupled over that time frame (by the way, the terrible economy of the Great Depression does not alone explain IBM's drastic fall. The company had traded at an irrationally high 60-90x earnings throughout the 1910s and 1920s. As soon as CEO Tom Watson said that the company was stockpiling unsold parts at its factories, the stock fell like a stone).
3. It is very difficult to gauge the appropriate price to pay for an initial public offering. When I determine the appropriate price to pay for an ownership stake in the company, I like to have some historical context to base my decision such as: What were the company's earnings during the last business cycle? How did it hold up during the last crisis? What kind of debt is normative for this company? What's a typical earnings multiple placed on this stock? Essentially, I want details about the company's profit history. With an IPO, you have to make a naked judgment call. Graham was skeptical that a fresh offering provided enough details to make an informed decision about the proper valuation of a security.
As investors, we have 15,000+ stocks already on the market to choose from. In the early 1990s, when Warren Buffett didn't own any international stocks in the Berkshire portfolio, he quipped, "The United States has a trillion-dollar stock market. If I can't make money here, I shouldn't be your manager." Well, that's how I regard IPO investing. If I can't find good ideas from the 15,000 stocks already in existence, I shouldn't be in the game. I have no idea what the ultimate result of the Goldman lawsuits will be, but my review of the document I cited earlier in this article did not exactly enhance my faith that the big bank underwriters are fairly pricing the IPOs that they are taking to the market. And even if I did have faith in the underwriting, I would still elect to follow Graham's advice: the IPO market is hard to value, rarely has good ideas, and the price usually falls shortly thereafter. Investing is hard enough without entering a niche world with such unfavorable dynamics. I like to get in the habit of making bets when the odds are in my favor. For every Google (GOOG) public offering, there are a hundred eToys out there.