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IPO investing used to be in. All the cool kids were doing it. Then came 2011 when the darlings of Web 2.0 did a group belly flop: Groupon (NASDAQ:GRPN), Pandora (NYSE:P), LinkedIn (NYSE:LNKD) and Zynga (NASDAQ:ZNGA) are all down or flat since going public. Yet the thrill of being served a slice of IPO cake is still frosting to investors. So here's the truth about IPO investing: it's a gamble in the best of cases, a losing strategy in most. Not to say that when Facebook (NASDAQ:FB) goes public (expected later this year) you won't see the now-familiar meteoric first day of trading. But the first day is for hedge fund traders and big institutions. You're an investor and that means knowing when to sell, as well as when to buy. And for the record, buy-and-hold has a poor track record with IPOs, as we'll discuss below.

Academics who study the market for IPOs have long known that companies going public and the investment banks that advise and raise capital for them purposefully underprice their stock. There's also a large body of research showing that over the longer term, 2 to 5 years, IPOs tend to underperform the broader market. One explanation for this lackluster showing is that IPOs tend toward smaller, growth-oriented companies (Duh! That's why they're going public). The Fama-French model (a time-tested method for explaining investment returns) that we and many other money managers use to allocate investments mathematically does a good job of capturing those poor returns from small, growth stocks. In other words, it's not going public that hurts investment returns - it's investing in the type of companies that tend to go public. That's one prevailing theory, at least, and a lot depends on the sample being studied and the period of returns.

Another truism about IPOs that may turn out to be wrong is the notion that insiders use their knowledge and positions of influence to grab IPO stocks at prices the rest of us can't, only to flip those stocks to us at the end of the day's trading when all the optimism and publicity have peaked. An intriguing paper published last year by Hafiz Hoque and Meziane Lasfer of London's Cass Business School shows that insider activity does correlate to IPO returns, but in the opposite direction. That's right, company board members are net buyers on IPOs that perform relatively poorly and net sellers on the ones that do relatively well. Even more interesting is that this only applies to IPOs; for already public stocks, the academic literature has established that insider buying and selling can predict investment returns. So IPOs aren't just a losing game in general, they defy some of the common sense findings the investment community lives by.

Which brings us to the current crop of tech IPOs. No one would call Groupon or LinkedIn tiny - Pandora, the smallest, has a market cap of nearly $2 billion at this writing. And while "growth" has its own range of definitions (a common one is a high price-to-book value ratio) these companies have very real revenues, cash flows and business models compared to the go-go years of the late 1990s. There's little doubt that these companies will be around and profitable in five years' time, yet their investors' optimism has proven short-lived. Is it the state of the economy, the fact that they are all to some extent online products facing fierce competition or did their investment bankers resist the urge to wildly underprice their IPOs the way we've grown accustomed to? Maybe all three, or maybe a small sample in a turbulent market says nothing about the companies and a lot about statistical fluctuations.

If small companies don't do well post-IPO and bigger established tech companies haven't recently done well, what does that mean for the white whale that is Facebook? Recent estimates put its value at $100 billion, with $10 billion to be raised for the IPO. For reference, a post-IPO valuation of Google from 2004 put its worth at a mere $27 billion: chump change to Zuckerburg & Co. Might Facebook's sheer size make it immune to the well-documented struggles of its Internet peers? Some say yes, others no. But don't be surprised if come June when Facebook goes public you see the post-IPO stock climb to an outrageous price followed closely by a drop back to reality. If that sounds like a sure thing, and many on Wall Street insist it is, you're ready to be an IPO investor.

Source: IPOs Are More Than Just A Losing Game