Facebook. Twitter. LinkedIn. Zynga. Groupon. LivingSocial.
One of my “Ten Sure-Fire Predictions for 2011,” posted in early January, was that this year would be the biggest for Internet initial public offerings since the first dot.com boom. It’s only mid-February, but barring a sudden market sell-off, you can take that one to the bank.
Amid some media hand-wringing about a new dot.com bubble, IPO activity is picking up nicely; some Internet companies that already have gone public have done very well; this new wave of dot.com debutantes appears to be profitable (no pets.com here), and there’s great investor interest that can lure some of the trillions of dollars in cash that’s been sitting on the sidelines.
The IPO Market Is Back
If you think this rally has been nothing but a government-induced bubble, you’ll no doubt see this as yet another sign of a market gone mad. But if you believe the bull market has a way to go, these new issues may add fuel to the market’s fire and could be a good place to put a small part of your money. I’ll tell you how later.
But the boom is definitely on. According to Renaissance Capital, a Greenwich, Conn.-based investment firm specializing in IPOs, proceeds from global IPOs hit $176.1 billion last year, more than double the volume of either 2008 or 2009.
So far in 2011, $10.7 billion in IPOs have come to market, a 36.1% jump from the same time last year. And most striking, US markets are setting the pace.
“In 2010, Hong Kong had half the global [IPO] market. Our share was 20%,” said Kathleen Smith, a principal at Renaissance. “So far [in 2011,] our share is 55%,” and Hong Kong has had no IPOs.
And although some of the stocks going public here are foreign companies with American Depositary Receipts, many are US-based.
Sizing Up the Hot Prospects
Of course, everybody’s watching the new dot.com stars, most of which are still private, but probably won’t be for long. If there’s a bubble, said Smith, “it’s certainly in the pre-IPO market. There’s more hype than I’ve ever seen on these companies before they’ve filed.” The huge scarcity of privately traded shares may be a big contributor to that.
So far this year, we’ve seen Demand Media (NYSE: DMD) complete an offering, while Internet radio company Pandora Media and business-networking site LinkedIn already have filed prospectuses.
The pre-IPO valuations on some of these are jaw-dropping. Online coupon purveyor Groupon famously turned down $6 billion from Google and is now supposedly worth $15 billion. Internet game site Zynga is valued at $7 billion to $9 billion, social messaging service Twitter at more than $8 billion, while LinkedIn may be worth $2 billion or more.
Facebook, as we know, recently secured a new round of financing from Goldman Sachs Group, Inc. (NYSE: GS) and the Russian company Digital Sky Technologies that valued the social-media juggernaut at $50 billion.
Those numbers sound pretty outrageous, given the slim profits most of these companies have posted so far. But Smith points out that these companies will be profitable by the time of their IPOs—unlike many that went public during the dot.com bubble--and when they publish their prospectuses, investors will better assess their correct valuations.
Also, some Internet IPOs already have done quite well. Ancestry.com (Nasdaq: ACOM) is up 137.5% from the close of its first day’s trading in November 2009. OpenTable (Nasdaq: OPEN) has soared 224% since May of that year, while Financial Engines (Nasdaq: FNGN) is up 52.5% in its first year as a public company.
And she says the first-day “pop” of IPOs has averaged 10%, pretty much in line with historical averages and way below the madness of the dot.com days.
That could change quickly when the big-name IPOs hit the market. Smith cautions investors not to buy at the IPO (most of us couldn’t even get in to these offerings, which are reserved for big institutions and the most well-heeled clients of the underwriting firms), but to wait for the end of the trading day or buy in the after-market over the ensuing weeks.
How to Invest More Safely in IPOs
Smith says investors should look for four things:
- Strong barriers to entry—something proprietary that protects the
company from competitors
- A reasonable valuation based on earnings and cash flow
- Good governance—a truly independent board of directors
- Whether the company is in the right sector of the market
In the 1990s, too many investors were burned by hot Internet stocks that flared up like supernovas and then fizzled. So, a mutual fund or ETF tracking these stocks may be the way to go—and I would allocate only 2% to 5% of your total portfolio to it.
The Renaissance Global IPO Plus Aftermarket Fund (IPOSX) buys selected IPOs at the close of their first day of trading and sells them after two years. Unfortunately, it has a pretty high expense ratio (2.5%) and trails the Nasdaq Composite index over the last two and five years.
The FirstTrust U.S. IPO Index Fund (NYSEArca: FPX) ETF tracks the IPOX 100 U.S. index, investing in stocks seven days after their IPO and selling after 1,000 days. It has outperformed the Nasdaq handily over the last two years, but trails badly over the last five. Its expense ratio is 0.6%, relatively high for an ETF.
You also can find broader mutual funds that invest in IPOs, although Russel Kinnel, director of mutual fund research at Morningstar, doesn’t recommend them.
“I wouldn’t go out of my way to buy a fund likely to get into IPOs,” he said. “IPOs historically haven’t been great performers … so buying at the offering price hasn’t been that great an investing strategy.”
“Even if you thought they were,’” he continued, “1. you don’t know which funds will buy [them], and 2. they may not be too big a piece of the fund.”
All true, but there are several clues.
Morningstar prepared a list of the funds with the largest holdings in Google stock around the time of its 2004 IPO (although we don’t know whether these funds actually bought in at the IPO). I’ve stripped out index funds, and here are the top ten:
According to Morningstar, Fidelity Growth Company (Mutual Fund: FDGRX) owned Google near its IPO and recently was among the biggest holders of Open Table. T. Rowe Price New Horizons (Mutual Fund: PRNHX) had a top-ten stake in Open Table and Financial Engines, while Lord Abbett Developing Growth A (Mutual Fund: LAGWX) recently owned Open Table, Financial Engines, and Ancestry.com.
The Lord Abbett and T. Rowe Price funds have set the pace recently, but only Fidelity Growth Company (which I own in my retirement account) beat the Nasdaq over the past five years. All these funds have expense ratios of around 1%.
Another possibility: You can buy the FirstTrust ETF or one of these funds plus your favorite IPO stock (after reading the prospectus thoroughly, of course)--but watch the market like a hawk and keep your exposure below 5% of your holdings.
Vigilance and diversification are the best defense against big losses. Dot.com boom 2.0 looks very promising, but who really wants to get fooled again?