There is a common belief that the best way to play IPOs is to buy on the day a company begins trading and then ride it higher throughout the day. Actually, thanks to Facebook (FB), this belief is now being challenged, as FB has lost more than half of its valuation from its $45.00 high on the day of its IPO. However, some still believe and will argue that the best way to play IPOs is to buy the day a company begins to trade, as investors constantly seek the next LinkedIn (LNKD). However, investors have this belief all wrong, almost in reverse, and are attempting to buy the companies they should be avoiding and are avoiding the IPOs they should be buying.
IPOs to Avoid
Last year, IPOs from high-profile Internet-based companies such as LinkedIn, Groupon (GRPN), Zillow (Z), and Yelp (YELP) created a significant amount of buzz and resulted in Facebook being the most highly anticipated IPO ever. The reason was because of large pops the day that these Internet-based "companies" began trading which led investors to believe that they could simply buy a stock the day of its IPO and return enormous gains. However, the truth is actually to the contrary.
The truth is that these high-profile Internet companies, which I call "websites", begin trading with such large premiums that retail investors never have the opportunity to buy the stock at its IPO price. The stocks have opened with premiums of anywhere between 20% and 80%, therefore leaving the retail investor to buy the stock well above its already overvalued price.
If we were to look back on all the Internet-based companies that filed IPOs in the last two years, we would find that nearly every single company is trading with a significant loss. These companies were significantly overvalued at their IPO price, and then after gains on its first day, it would've taken five years of 100% fundamental growth just for the company to be attractive in terms of valuation. Therefore, these companies were a no win situation for retail investors, where only those who could purchase at its IPO price would benefit, and everyone else has lost!
IPOs to Buy
Instead of buying high-profile overvalued Internet-based companies, you could change your strategy to buying companies with physical locations that do not rely on advertising, clicks, or members for social media. Not only do these companies perform much better, but also use the money raised in IPOs to expand and grow with physical locations. Even established companies such as GNC Holdings (GNC) and Dunkin' Brands (DNKN) have seen explosive growth since their IPOs, allowing both to expand with better locations.
Between the years of 2007 and 2010, both DNKN and GNC saw very mediocre gains in terms of growth, but in 2011 (year of IPO), both companies saw significant earnings growth. During its most recent quarter, GNC posted revenue growth of nearly 20% and earnings growth of 85% year-over-year. During the same period, DNKN grew its fundamentals by nearly 10%, and neither of these two companies is in its growth phase, both are well-established, yet are growing and returning nice gains to shareholders. I am not saying that either of these two companies is a good investment, rather showing how the money raised during an IPO can change even an established company (rather than FB acquiring Instagram with no revenue for a billion), although there are some very good opportunities in companies that are in its growth phase that recently filed for IPOs.
Michael Kors (KORS) has increased by 120% since December 19 and Five Below (FIVE) has increased by 18% since its IPO in July 2012. Both companies are in aggressive growth mode and are using the money raised during IPOs to grow even faster. KORS grew revenue by 68% and has done a good job at keeping expectations below the speed of its growth. Five Below is a retail company with 192 stores and $325 million in sales; however, the company is growing rapidly, with a goal to expand to 2,000 stores in the next few years. Therefore, despite the fact that both stocks may appear overvalued, they are both valued correctly in terms of future and current fundamental growth. In addition, both are much more established, and are safer, than any website with weak barriers to entry that could become a fad. As a result, with impressive performance, strong fundamental growth, and much more attractive valuations compared to Internet companies, it seems logical that stocks in this category with physical locations are much better IPOs than overvalued websites.
My question to all investors is why invest in one of these websites, and for such a large premium? With it being only 12 years since the dotcom bubble burst, it seems almost absurd to pay such large premiums for a company based on the Internet whose goal is to increase its number of free members, or increase its number of reviews, or "likes". And with Internet-based companies, there are virtually no barriers to entry as most of these "companies' will not exist for longer than five to 10 years, remember Myspace?
History tells us that of all the Internet-based companies, only a few will thrive and grow larger over the course of several years. Back during the dotcom era, all companies disappeared as quickly as they were formed, with the exception of Google (GOOG) and Amazon (AMZN), which broke all the rules and have grown to an excessive margin over the last ten years. With that being said, one must acknowledge that there are many differences between now and the dotcom era, as back in the late 90s, there were companies going public that didn't even have revenue. Therefore, it is encouraging that the Internet companies of today do have substantial revenue, although valuations suggest that all should continue to grow year-after-year.
In the end, it's not a question of which company will stand the test of time, but rather a question of valuation and barriers to entry that will determine the long-term success of a company. The key takeaway is that companies with physical locations use the money raised on IPOs to grow and expand and become much more efficient companies. Even established companies such as GNC can use the money earned from an IPO to grow rapidly, therefore imagine what a company such as KORS or FIVE can do in its growth phase. Also, most of the companies with actual business operations that create products have performed very well following IPOs, and history shows us that the money raised for these companies produces sales which ultimately results in stock performance, therefore presenting good opportunities for investors. As a result, the next time a high-profile website announces its IPO, with an expected P/E ratio of 200 and a price/sales of 15, keep in mind the less popular IPOs of fast-growing companies with more attractive valuations that have a long history of outperforming the website IPOs, and could return large gains for many years to come.
Disclosure: I am long FIVE.