Facebook Hype Aside, IPOs Generally Aren't Good Investments

| About: First Trust (FPX)

By Matt Delman

The impending initial public offering, or IPO, for Facebook (NASDAQ:FB) was in the news again this week because of a CNBC report on Tuesday that CEO Mark Zuckerberg has been so focused on running the business---he acquired Instagram recently and bought 650 AOL patents from Microsoft (NASDAQ:MSFT)--that there's been precisely zero time to prepare for the traditional investor road show. Now, instead of a mid-May offering, the company might start the road show in mid-May. This would place the actual offering either at the end of May or in early June.

I mention this because of the mass amount of hype the Facebook IPO has received since the company announced the offering in early February. I even wrote a column not long after the announcement, wondering if it was a good idea to invest in the company at all.

I'm not planning a re-hash of that topic today, since I still agree with my original opinion. No, what I'm instead curious about is whether it's a good idea to invest in a company's initial public offering whether it's hot or not.

Let me explain. If you purchased $10,000 worth of Microsoft when it went public in 1986, you'd have $29 million today. That's assuming, of course, that you held onto all your stock and just let it ride without making any changes to your position.

Today, we know making that purchase 26 years ago would've been a very profitable move. But for every IPO that eventually makes early investors loads of money like Microsoft, there's at least one more that debuted to loads of fanfare but failed to perform.

Bloomberg last year did a study on the 25 hottest IPOs of 2010 and 2011, and discovered that 20 of them--a full 80%--fell an average of 50% from their offering price (as of November 4, 2011 when Bloomberg released their data). Demand Media (DMD), one of the stocks on the chart, fell a full 68% between its January 28, 2011 IPO and the time of that Bloomberg chart. It closed Thursday at 6.99 (The stock debuted at 20.44).

That IPOs are incredibly risky almost goes without saying, since it's entirely possible that a company which is not well-run will go public during a bull market and have their stock shoot through the roof only to tank in the near term. It's for this reason that purchasing stock in a newly public company at the IPO price isn't always the best thing to do.

And investing in a "hot" IPO is an even worse idea. When popular companies such as Facebook decide to go public, it behooves company management and early investors to convince the market that the company is a good investment. This way, those insiders and early investors can turn a profit from their stake in the company. The people who will become millionaires from the Facebook IPO, for example, are those early investors or employees with a lot of stock options.

For individual investors, it's better to wait a few weeks to see what trading range the company falls into. For a more specific guideline, I'll defer to Mike Cintolo, who wrote in the February 8 issue of Cabot Market Letter that "as with any new issue, we prefer to see some consolidation after the offering, usually for two to five weeks, followed by a push to new highs."

This consolidation followed by a push shows that institutional investors are interested and will protect you from a sharp near-term loss. I'll use Demand Media as an example again. After the IPO at 20.44, the stock went as high as 24.55 on March 4, 2011 before entering a persistent downtrend. It didn't build any sort of base until almost August 2011, when the stock fell to under 10, where it's stayed ever since.

With this high risk attached to investing in a newly public company, it's a fair question to ask if you should bother putting any money into an IPO. And the best way to answer that is to look at the company's fundamentals (assuming you don't want to wait for a consolidation).

If the fundamentals of a company are strong--they're in a market with high barriers to entry, have a revolutionary product or service and show strong sales and earnings growth--then the company might be a good investment. Still, when you invest without the benefit of a healthy chart--and in particular evidence that institutions are supporting the stock--your risks are increased. In such cases, I suggest keeping your position small, since that will leave you able to let the position ride without worrying about losing too much money.

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