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IP uh-Oh

By: Investor Solutions

By: Investor Solutions

Years ago we published an article (IPO’s: A Great Investment Opportunity or a Sucker’s Bet?) on the pitfalls of investing in initial public offerings if you weren’t in on the ground floor. Claims of an Internet rally 2.0 on the heels of several recent offerings, with a slew more expected, and LinkedIn’s impressive first day, are attracting a lot of attention. Seeing how IPOs have come back into vogue lately I think it’s prudent to revisit the topic.

Historically the majority of IPOs underperform the market. Even on average factoring in the high flyers, as a whole, the IPO market has not been an attractive investment space. Scary enough is that the return figures listed in news stories that hype the success of the stock, are based upon the understanding that you were able to purchase shares at the IPO price, which most people aren’t able to. Shares of an IPO at the offering price are saved for management, employees, friends and family of employees, investment banks, hedge funds, and high net worth clients. Investment banks of course get a discount, as they are the ones paid to help disburse the shares. In the unfortunate event that you bought into the hype, purchased shares in the secondary market and ignored the ungodly high valuation, you’re in for an even more difficult ride than those previously mentioned insiders.

Our previous article offered some good facts about IPO returns. Ongoing research by finance professors and IPO experts like Tim Loughran and Jay Ritter demonstrated that the average return on IPO’s issued between 1970 and 1990 is a mere 5% annually (median returns might actually be lower). Compare that to the S&P 500, which produced an annualized return of 10.81% for the same period. According to Jay Ritter, finance professor at the University of Florida,” the typical IPO lags for up to five years after it comes to market”. Similarly, Ritter and Professor Ivo Welch have concluded that IPO shares perform 23.4% worse than shares of comparable seasoned companies in the first three years and actually have negative returns in that time period. This data is before the dot.com bubble burst, so the numbers including that time period would look even worse.

More recent data for the year 2005 stated that there where 147 IPOs, based on the first price the public was able to get them at they returned an average of 3.7%. Without the 8 70% returners you would have a – 2% return. Think again if you think it’s easy to find those 8 companies that returned 70%. One of the biggest losers, Refco, started out a big gainer before the CEO of the company was found guilty of fraud and concealing company debts. This just shows you never know what you are going to get with a private company that hasn’t had to show it’s financial records before.

DOTCOM 2.0

Flashes of 2001 have companies rushing to the market to cash in on the excitement. Some companies aren’t even in need of cash they’re just looking for the exposure. Yandex, LinkedIn, Zynga, Facebook, Groupon, Bankrate, and Pandora have all had, announced or discussed an IPO of their company recently. Are these companies better than the first time around? Some of these companies are actually making a decent profit, but their valuation seems a bit excessive. In their article, http://www.bloomberg.com/news/2011-05-24/why-linkedin-bears-like-haverty-say-plunge-is-inevitable.html, Inyoung Hwang and Nikolaj Gammeltoft argue that LinkedIn’s valuation at these prices cannot be justified. They say LinkedIn is not growing fast enough and should trade 60% lower. They say LinkedIn would have to grow revenue 148% over the next two years to bring its price / sales ratio in line with the industry. This does not sound like the kind of investment you want to make.

LinkedIn, like other IPOs, has to face various hurdles in order to maintain its current price. http://www.bloomberg.com/news/2011-05-25/is-there-a-way-to-make-linkedin-add-up-.html. First, a lot of IPOs underestimate demand and artificially inflate their price by issuing a small fraction of their authorized shares. LinkedIn only made public about 7.84 million shares for its IPO. Second, IPOs are commonly subject to a 180-day lockup period during which insiders cannot sell their stake. This is the time when the people who gained the most are able to lock in their profits or walk away if the investment has done poorly. On November 18th 85.7 million more shares of LinkedIn become available to sell. Third, as the long list of companies who are currently waiting finally go public demand in them will diminish the interest in shares of earlier IPOs. Also, like Refco, these companies will face scrutiny of their financials for the first time. The public just doesn’t know exactly how their business is tracking until then.

Another anxiously awaited IPO, Groupon, has its own financial issues, but you wouldn’t know it based on some of the hype and articles written about it’s upcoming IPO. http://finance.yahoo.com/news/Groupon-is-Effectively-minyanville-3764150861.html?x=0&.v=1. Groupon took to using debt to facilitate a revenue hyper-growth strategy. While their revenues are large at $644 million for Q1, the current debt they assumed is more than twice their current assets at $520 million and because of this they are losing money each quarter. It’s very important to understand why a company is selling shares to the public and in Groupon’s case it is most likely because they desperately need the cash. Freescale, Bankrate and Spirit Airlines are using proceeds to pay down debt. While others, like LinkedIn, just want to take advantage of the opportunity, as an exit strategy, as apposed to using it to drive growth. If you don’t believe me, take a look at their S-1. “The principal purposes of this offering are to increase our capitalization and financial flexibility…” basically to make their balance sheet look nicer, “…increase our visibility in the marketplace…” make news headlines with their IPO and be opportunistic, and “…create a public market for our Class A common stock” give our ownership an exit strategy for their investment. For LinkedIn’s business platform cash investment doesn’t translate into revenue growth.

SHORT TERM PERFORMANCE

What this doesn’t show is that the first day pop usually happens very quickly and it’s impossible to capture the entire move. Based on volume analysis, LinkedIn’s average price was around $90 and that’s being generous. What this means is that the average investor was down around 15% on day one. In the table above, all of these stocks above are down dramatically from their first day highs. The initial pop only took them so far and now they are down below their opening price even. This has occurred rather quickly, for most it took less than a month. For all of these stocks, any retail investor who got in on the best price they could, and held on, still lost a good portion of their money. In comparison the S&P 500 is only down 5.6% since May 4th.

CONCLUSION

These stocks may recover, but based on the study mentioned above they aren’t likely to perform as well as the market index much less a diversified portfolio. So you would be better served maintaining a properly allocated portfolio and staying away from the so-called “guaranteed” gains of the IPO market. It hasn’t been too long since we learned our lesson to avoid pilling on and buying into the hype. Let’s not fall back into this trap, that’s exactly what investment banks what you to do so they can make money of you. They are counting on a short-term memory and an unrealistic expectation for fast money. This time around there are no excuses no one is clueless. Risk takers are better served shelling out a little money to go skydiving. When it comes to your money stay smart and limit your mistakes.