How to get rich quick: (a) find a cache of pirate booty buried underneath the shed, (b) discover a long-lost Picasso behind the camping gear in the attic, or (c) get in on the ground floor of the next social networking IPO.
Barring a sudden uptick in the quantity of gold doubloons pulled out of suburban backyards, it is the last of these that is likely to hold the most appeal to modern-day investors. While an initial public offering (IPO) is ostensibly about raising capital for a given company, for many investors, it is the ultimate in get-rich-quick schemes: the stock market equivalent of making blackjack, throwing a natural, and pulling three bars on a single visit to the casino.
Then again, that may be understating the point. Just look at the numbers: professional social networking firm LinkedIn “popped” (to use the cant of the pit trader) 84 per cent above its offering price in its first trade of the day. For Zipcar, the car-sharing company, the first-day pop was 66 per cent. Internet music company Pandora Radio popped 60 per cent. Ladies and gentlemen, we have ourselves a winner.
Such is the psychology of the IPO, a high-risk, high-stakes game in which frenzy and hype play as much a part as profits and revenues. While some may criticize the fever that surrounds many IPOs as both irrational and dangerous, there is something undeniably glamorous and macho in betting big on new companies on the cutting edge of the business world. If you’re brave enough, bold enough, and quick enough, you can make millions in a matter of minutes: tangible proof to yourself and others that you are, indeed, one of the smartest guys at the table.
Of course, getting in on the game isn’t always easy. One doesn’t simply invest in an IPO—at least, not at the offering (pre-market) price. One has to know someone. An important someone, preferably someone from the C-suite of the company going public or the investment bank(s) bringing the shares to market. These are the people who have access to pre-market shares at pre-market prices. Throwing a few hundred (or thousand) to top clients, suppliers, friends, family, or the guy who delivers your morning newspaper, is a long-standing Wall Street tradition.
It is this whiff of country-club exclusivity that has led some market gurus (among them such heavy hitters as Benjamin Graham, Jeremy Siegel, and Canada’s own Stephen Jarislowsky) to question whether IPOs aren’t simply a legal form of the age-old Ponzi scheme. Those who get in early make money, regardless of the underlying value of the stock in question. Those who get in late are often left holding overvalued, overhyped stock that has nowhere to go but down. That is, unless they can convince another sucker to take it off their hands.
The long-term performance numbers seem to back up such opinion. In a seminal review of post-IPO performance, University of Florida professor Jay Ritter determined the average first-day return of over 7,314 United States–based IPOs that came to market between the years of 1980 and 2008 was an impressive 18.1 per cent. However, the three-year performance of those same 7,314 IPOs actually underperformed the broader U.S. stock market by fully 19.8 per cent. So much for buy and hold. Not that IPO investors seem much bothered by such statistics: if anything, reports of massive first-day pops continue to drive demand for new issues.
Making Sense of the IPO Game
One investor who knows his way around the IPO table is Josef Schuster. As a former economist and derivatives trader with a PhD from the London School of Economics and Political Science, Schuster is well versed in both the dreams and reality that typically accompany IPOs. So much so that he has created a series of market indices that track the long-term performance of global IPOs and spinoffs.
From his vantage point, Schuster believes the current IPO market is healthy. “The U.S. IPO market has been solid,” he says. “There were 99 notable IPOs in the U.S. last year, in line with the historic average.” As Schuster explains, that’s good news not only for day traders, but for the economy as a whole. “Because IPO companies are typically growing companies that hire, more IPO activity is contributing to improving the U.S. employment picture.” It’s also a boon for the financial services industry, which has seen more than its fair share of layoffs over the past several years. “Increased deal flow typically also adds to the bottom line for the investment banking industry,” Schuster notes. “This is important in times of challenging fixed income markets and tougher banking regulation.”
While Schuster admits the hype for big-name IPOs has been considerable of late, he is reluctant to label the IPO market overheated as a whole. “It’s a selective market,” he says. “For the right deal, there appears a lot of pent-up demand.” As Schuster admits, that demand has led to sky-high valuations for some IPOs, but not all. “While new economy IPOs have been excessively valued, old economy IPOs have been coming to market fairly attractively.”
If there’s one thing Schuster wants potential IPO investors to know, it’s that the IPO game isn’t a short-term gamble. Rather, it’s a long-term vote of confidence in the financial vitality of a given business. “Many investors look at IPOs from a high-frequency, short-term trading perspective,” he says. “In order to benefit from the long-term potential [of IPOs], investors [should think] in terms of a minimum five-year commitment. Then, the odds are good that part of their portfolio actually will have doubled versus the S&P 500.”
As Schuster explains, although first-day pops may generate headlines, it’s the post-IPO takeover that generates profits. “Most takeovers in IPOs occur during the three to four year post-IPO trading window. It’s been a real, unnoticed trend and has added a good portion of additional returns over time.” While identifying a post-IPO takeover isn’t always easy, those who manage to hang on to their IPOs for more than a few hours can often add a good deal of extra oomph to their portfolios. “Key holdings such as Motorola Mobility, SuccessFactors, or PharmAsset have recently been taken over at a big premium,” Schuster observes.
Same goes for the poor cousin of IPOs: the corporate spinoff. “We [consider] spinoffs and IPOs together as one investable universe,” Schuster says. “The breakup event acts as a catalyst [for] positive corporate changes over the first few years, much like the acquisition of cash with IPO companies as they go public.” Perhaps more importantly, spinoffs allow investors to avoid some of the risk inherent in putting one’s money behind young, often unproven start-ups. “Because spinoffs are typically larger, S&P 500–type companies, they are less risky and perform accordingly versus IPOs.”
Getting in on the Game
Looking for a seat at the IPO table? Schuster offers some simple advice: “Be diversified,” he says bluntly. “No single name should have more than 10 per cent [of your portfolio] at any time.” He is equally candid when asked for his thoughts on first-day speculation: “Don’t do it if you don’t combine it with a long-term perspective on the respective IPO.”
While the potential for shoot-the-moon type returns is always there, those who approach IPO investing with a quick-flip attitude do so at their own risk. “The median initial return for participating in U.S. IPOs was around 5 per cent last year,” he says. That’s comfortably higher than both the Russell 2000 small-cap index (which posted a negative 4.18 per cent return last year) and the broadly based S&P 500 (which was up a grand total of 0.04 per cent). But, as Schuster points out, it’s much smaller than the big numbers typically seen splashed over the headlines of the financial section.
All the more reason for investors to be picky when evaluating IPOs. While some offer attractive bang for the buck, many others fail to live up to their hype. It’s up to the individual to determine which category a given IPO falls into—a task that goes far beyond the number of column inches a deal attracts in the financial press. “We look at IPO characteristics such as float, size, sector, initial return, domicile, or how a company manages its earnings pre-IPO,” Schuster says.
Schuster believes IPO investors need to pay particular attention to valuation of IPOs, and be wary of buying into the “gotta have it” mentality. “Anything trading on a high multiple of revenues at the IPO should be avoided,” he says. That includes most of the big-name social networking IPOs that have come to market lately. “IPO investors in Groupon, Zynga, Pandora, HomeAway, or LinkedIn have not been compensated for taking the big risk of investing at the IPO.”
Yes, yes, but what about the biggest social networking company of all—Facebook? When the company filed its S-1 on February 1, Wall Street was quick to press the “like” button. Schuster, however, remains skeptical.
While details still have to be hammered out, word on the street suggests the deal will give the company a valuation of $75-billion to $100-billion, making Facebook more valuable than stock-market stalwarts such as Visa, Disney, or our own Royal Bank of Canada.
“The proposed Facebook valuation leaves very little immediate and even medium-term upside,” Schuster says. Just for reference, Schuster notes Google’s IPO investors paid $85 a share for a 7.3 per cent slice of the search engine back in 2004; the sale valued the company at about $23-billion, less than a quarter of Facebook’s projected value. “Investors should ask themselves: with hindsight, would I have bought Google at around $330 at the IPO?” If the answer is no, Schuster suggests waiting before becoming the company’s friend.