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Initial Public Offerings – Good or Bad Investment Option?

Caveat Emptor Tag Should Hang on Every IPO Share

by Anton Aleksandrov

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“The IPO of The Century”

On Thursday, 2 February 2012, Facebook announced that it was going to undertake what would amount to the biggest-ever stock market listing for a technology company. As it happens,I first heard of the news on Facebook – a sometime “friend” in my network, with whom I had irregular contact – mainly concerning his champagne importing business -posted on his wall a link to the Guardian’s live news feed covering the announcement. If my memory serves me right, back then my acquaintance described the Facebook IPO as a killer deal totally worth investing in and stated he’d gladly get a piece of that cake. For his sake I hope he abstained,since the “IPO of the century”tanked...badly.The shares issued on 17 May at the pre-float price of $38 took a downward ride and by September had lost more than half of their float value. Since then,Facebook has shown signs of hesitant recovery,with its share price generally climbing and closing at $31.30 on 10 January 2013. Despite the recent advances though, Facebook’s shares are almost 18 percent below their issue price, turning the Facebook IPO from the IPO of the century to the biggest float flop of 2012.

Do All Initial Public Offerings Lose Value?

Absolutely not, there are plenty of good performers out there – LinkedIn, Spirit Airlines, Guidewire and Zipcar all saw their share value rise after their initial public offerings. However it certainly does feel that recently we’ve been reading mainly about IPO flops,including the aforementioned Facebook IPO and other disappointments such as Zynga, Groupon and Prometheas.

To get a more general sense of how recent floats have performed,one can look at three major indices:

The Bloomberg Initial Public Offering Index (BIPO) is a capitalisation-weighted index, measuring the performance of US stocks during their first publicly traded year.

The Bloomberg Great Britain IPO Index (BEUIPOGB) does the same thing for stocks in the UK.

The FTSE Renaissance Global IPO Index (IPOSG) tracks activity in the global IPO market and incorporates a rolling two-year population of IPOs.

Using 13 January 2012 as a base date, the BIPO has advanced by 2.01 percent and currently sits at 2,1750.00 with a 52-week range of 1842.10-2500.83. In contrast, the BEUIPOGB shed 71.96 percent to 14.80 with a 52-week range of 13.75-63.46. The only substantial winner has been the IPOSG, which gained 19.76 percent and currently stands at 113.39 with a 52-week range of 91.27-113.80.

These indices paint a more global picture of the state of newly issued equities – in the US and the UK companies that went public on average saw their share price either advance slightly or decrease, while the worldwide trend was the opposite. In fact the FTSE Renaissance Asia Pacific ex Japan IPO Index, which captures the essence of IPO activity and performance in the Asia-Pacific region, rose by the impressive 22.6 percent, in the process outperforming by a long shot its Western counterparts.

In his book The Only Guide to a Winning Investment Strategy You’ll Ever Need, Larry Swedroe, principal of and director of research for The Buckingham Family of Financial Services, cited four studies of historical data which showed how different investment strategies for Initial Public Offerings performed:

The first strategy was to buy every IPO from 1970 to 1990 at the closing price on the first day of trading and then hold each for 5 years. The results showed that the IPO investments performed seven percent below the benchmark performance of companies with similar market capitalisation and already trading.

The second strategy involved buying all Initial Public Offerings issued in 1993 and holding them until mid-October 1998. According to the study, the average IPO in this group returned 67 percent less than the S&P500 index.

The third strategy was to buy every IPO which between 1988 and 1993 raised at least $20 million, a total of 1,006 IPOs. This investment bundle underperformed the Russell 3000 index by 30 percent in the three years after going public. Out of all Initial Public Offerings included in the bundle, 46 percent produced negative results in the study period.

The fourth strategy was to buy all IPOs which rose 60% or more on their opening day and then hold them from 1988 to 1995. The results – this group underperformed the market by two to three percent per month or 24-36 percent annually.

Why Are Small Investors Losing from IPOs? Given the recent flops, there is a growing belief among retail investors that IPO actually stands for “it’s probably overpriced”. According to Chuck Jaffe from MarketWatch, the initial public offering process is built and managed in such a way as to create a predictable pop on its opening day, which later turns into a similarly predictable fall-back. This suggests the need for a new rule on the stock exchange – “When Wall Street gets excited by something new, investors should get nervous.”

The more buzz generated about an incoming IPO such as Facebook, the more retail investors get excited and ready to jump in on the opening day at what might prove to be a very inflated price per share. That inflation prospect is hardly surprising - IPOs are used both to fund the company and reward its founders and pre-float investors for their efforts and risk-taking.

Individual investors, on the other hand, seem to be the guys stuck in the back of a big road race – they might get by some of the runners in front of them but those at the starting line have already been assured a fast and easy win. The Wall Street firms and their favoured investors get to take a quick, short-term punt on huge risk-free profits on the back of inflated share prices. Whereas Joe Investor is often left relying on the “greater fool” theory – the idea that someone else at some point will come in willing to pay more.

Who Wins?

According to Alexander Haislip, author of Essentials of Venture Capital, the time is over when the wealth created by real companies producing valuable products spreads around to anyone with savings and access to a stockbroker. The winners now are private investment firms and venture capitalists. They participate in the true round of initial public offerings – typically investing in private fast-growing companies valued at £500 million or more and then capitalising on their explosive growth by effectively assuming the role of the IPO. The Facebook IPO was not a flop for these investors – many doubled the money they put in the social network.

Haislip gives as an example the cloud storage company Box, which recently raised $125 million (£77.5 million) from private placements in order to continue its growth momentum, expand internationally and build the tools to make it more appealing to large enterprises. And a year ago, the company did an $81 million (£50 million) investment round, which valued it at around $600 million (£372 million). If this had been 15 years ago, founder Aaron Levie would have had to take his company to the public markets and Joe Investor could have come aboard and watched Box grow from a $600 million (£372 million) valuation in 2011 tothe $1.2 billion (£744 million) it’s reputedly worth today. Instead Box remains private and if and when it does go public it will have passed its high-growth phase. The winners? That would be the private equity investors, the venture capitalists and the company insiders.

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