How You Should Play Zynga's IPO

Dec. 5.11 | About: Zynga (ZNGA)

Zynga is expected to begin trading in December (likely this week or next) and will be one of the most anticipated internet IPOs of the year. As of now, the price is expected to trade between $8.50 and $10 with a $9 billion valuation. The company's float will be higher than some of the recent IPOs with 14.3% of the company being traded, Groupon (NASDAQ:GRPN) offered 5%. There is no doubt that over the next two weeks Zynga's IPO will be one of the hot topics of the market, and will give investors a taste of the most anticipated IPO ever, Facebook. I can almost guarantee that on the day of its IPO the volume will be high and the stock will post large gains. And although many investors will buy the stock on the day of its IPO to capitalize on immediate gains, I will argue that buying Zynga (expected ticker ZYNG) on its opening day is a rookie mistake and is not the best way to play this stock.

Last week, on November 29, I wrote an article explaining to investors why it was time to buy Groupon (GRPN). At the time the article was published, GRPN was trading at new lows and had fallen 50% from the highs of its opening day. Since that time the stock has gained 25%, and although some would argue that my suggestion was luck, I argue that it was a calculated suggestion on how to capitalize on the most certain gains within the market.

When an internet based company files for its IPO, three things are certain: it will post huge gains during its IPO; it will then fall by a large margin; and it will post large gains once the stock falls 50% from its high price the day of its IPO. (To better understand this concept please click here to read the article on GRPN) There have been several internet based companies to file for an IPO this year and everyone of them have followed this pattern. I believe it's because of the strong opinions surrounding the companies. Because regardless of how promising a company such as: Groupon, Zynga, Facebook, Linkedin (NYSE:LNKD), Zillow (NASDAQ:Z), or Angie's List (NASDAQ:ANGI) may seem there is still a level of uncertainty that these companies are only fads and may become the next Myspace. These companies have low barriers to entry and have a strong likelihood for competition. Therefore, my belief is that a large number of investors buy a stock the day of its IPO to capitalize on the quick gains without having any intention to hold the stock for an extended period of time. This causes a domino effect among investors who sell the stock to avoid loss which then causes the stock to post large loss in a short period of time. However, as the stock falls 50% below its highs investors who are bullish then buyback the stock and it results in another domino effect, causing large gains in a short period of time.

My belief about why this trend occurs is purely speculative and is based on my perception of the behavior of investors. But the truth is that I don't know for certain why these stocks follow this trend. All I know is that this trend occurs, and has been identified in all of this year's IPOs, which is a large number of occurrences for it to be a coincidence. To better explain I have listed several high-profile internet-based companies that filed for an IPO during the last year. I have included the percentage of loss following its IPO; the level of gains after the stock reversed to post gains; and then length of time it took for each stock to complete the trend.

IPO Volatility
Company Ticker IPO High Drop Pop Trading Days
Linkedin (LNKD) $122.70 $63.71 $109.97 40
Pandora (NYSE:P) $26 $13.34 $20.04 13
Zillow (Z) $60 $23.96 $37.18 30
Renren (NYSE:RENN) $24 $6.23 $11.33 39
Groupon (GRPN) $31.14 $15.20 $20.70 19
Angie's List (ANGI) $18.75 $10.80 $14.25 10
Click to enlarge

As you can see from the data above, each of these high profile stocks posted an initial high the day of its IPO; then fell by a large margin in the coming days; and finally trended higher by at least 35% in a short period of time. The only exceptions are GRPN and ANGI, two stocks that are still in the initial phases of the trend. And although the level of gains, losses, and number of days it took for the pattern to occur are different, it still proves that this pattern is consistent for high profile internet based stocks.

Given this information, with a better understanding of this pattern along with its consistent occurrence, the question becomes how you should play Zynga once it becomes public. In my opinion, the best way to play the stock is to wait for the initial loss and then buy and ride it higher. I don't believe in buying a stock the day of its IPO is effective, because the stock usually opens with gains of more than 20% which will limit your return and possibly result in loss. Therefore, the best way to capitalize on the gains of a high profile internet company's IPO is to be patient and wait for the stock to fall. I believe the best way to limit confusion is to buy after the stock posts one day of gains following a loss of at least 40% from its high price the day of its IPO. And if we go by recent IPOs, this will occur within 25 trading days, and is certain to occur.

There may be a better way to capitalize on the gains of a high profile internet based company's IPO, but from what I've seen, this method always works, and in my opinion, if it's not broken then don't fix it. The market trades on technicals, and although I'm a fundamental investor and it kills me to admit this, it's the truth. My belief is that technicals control the short-term direction of a stock and ultimately create value while fundamentals control the long-term direction of a stock and allow you to capitalize on value. And since we are only talking about a short-term trend that occurs within a time period of two months I believe this is a trend that any and all investors should try to understand and learn how to trade. It's my opinion that buying a stock during its IPO is a mistake, and that investors can capitalize on large gains by simply being patient and waiting for the stock to fall. I urge you to explore the stocks listed in this article so that you may see how evident this trend presents itself. Because although I can't tell you when to buy Zynga, I can help you know how to buy Zynga, and if you are simply patient you can capitalize on a trend that's worked time-after-time on all the high profile internet companies.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.