IPO’s: Hoopla or One Heck of an Investment?

April 23, 2012

With all the media hype surrounding the Facebook IPO many investors, novices and seasoned investors alike, are chomping at the bit to get in on the action. One cannot deny the allure of being economically tied to a global game changer like Facebook. The company has truly transformed the way we communicate and do business. But, just because a company is successful and “cool”, does this mean it has a viable long term strategic revenue plan or that it might be a good investment too? Of course, not all IPO’s are created equal. There have been several very lucrative IPO’s that have proven to be good investments over time, but there are even more that have had the exact opposite experience. This article will explore the general area of IPO’s as an investment and determine whether these are viable investments that you might want to consider.

 What is an IPO?

An Initial Public Offering, or IPO, is the first sale of stock by a private company to the public. An IPO is also sometimes known as “going public. IPO’s are often smaller, younger companies seeking capital to expand their business. But, they can also be established, private companies looking for additional cash infusions.

In the case of the Facebook IPO, none of the aforementioned factors come into play. In fact, Facebook’s founder Mark Zuckerberg does not want the company to go public. The key reason Facebook is going public is because of an Securities and Exchange Commission rule that says that any private company with more than 500 “shareholders of record” must adhere to the same financial disclosure requirements that public companies do. That means filing detailed quarterly and yearly financial reports, and dealing with all the scrutiny that comes with a powerful company opening its books.

Companies that are going public usually hire investment banks to “underwrite” the process. Underwriting is the process by which investment bankers raise investment capital from investors on behalf of corporations and governments that are issuing securities, for both equity and debt.

The underwriter may put together a consortium of several investment banks and brokers to distribute the stock for the issuer. The underwriter agrees to pay the stock issuer a certain price for a minimum number of shares, and then must resell those shares to buyers, typically institutional clients of the underwriting firm or to its related brokerage firms. Additionally, each member of the consortium agrees to resell a certain number of shares to its most exclusive clients. For its underwriting and distribution services, the underwriters (think Goldman Sachs, JP Morgan and the Deutche Bank’s of the world) charge a very handsome fee plus the subsequent commissions for trading the stock.

IPO Performance

When a company goes public, much of the profit already has been made because the owners/original investors are harvesting their gains In general terms, IPO’s are usually only available to institutional investors on its first day of trading. Translation: hedge funds and mutual funds get first dibs on most IPO shares. Retail investors are typically shut out of early trading, instead having to buy in the secondary market after the IPO debuts. So if you are looking to profit from a quick trade during the first days of trading, think again. IPO’s tend to get priced slightly below market value in order to generate some buzz and create upward momentum (or a “pop”) in the first days of trading. Certainly some IPO’s have had successful debuts and subsequent price escalation and stability. But, once the glory fades, many IPO’s fizzle out not long after the stock begins to sell. Let’s pick on a few media darlings to provide some examples of this:

  • LinkedIn created a huge buzz with its meteoric rise on its IPO date (it opened at $45). But a month after closing at a price of $94 on its opening day, it fell to under $65. It’s trading around $99.30 as of this writing (4/23/12)
  • Pandora Media shares surged above its $16 IPO price moving as high as $26 a share, an increase of about 63% but shares cooled quickly. It’s trading around $8.50 as of this writing.
  • Groupon IPO shares soared in it’s public market debut last November. After pricing above its expected range at $20, Groupon’s stock rose $6.11, or 31% to close at $26.11. Fast forward a few months, it’s trading around $11.81 as of this writing.

Not convinced? Here are some interesting highlights from academic studies to support this:

  • Study by Purnanandam and Swaminathan reveals an interesting result that IPOs are systematically overvalued with respect to their fundamentals in the long run. (2001)
  • Study by University of Florida finance professor, Jay Ritter, concludes returns on IPOs during the five years after issuing under-perform firms of same size (market cap) by an average of 3.8% per year (data from 1970-2007)

For every successful IPO investment you probably have many more that disappoint for the average investor. Historically, many investment professionals and academics have warned against buying an IPO.  Research showing that IPOs are poor long term investments has existed for quite a while Frankly, I don’t disagree with them. Investing in IPO’s does not typically align with the objectives of a long term investors. Day traders might be better suited for such events, something we do not endorse. But, if you are still so inclined and decide that an IPO investment is a risk you are willing to accept, then as with any other investment decision that you make, do your homework. Frankly, if I was in the mood to gamble, I would much rather spend my money in Vegas where at the very least I can find some interesting entertainment and free cocktails.