The Facebook initial public offering (IPO) has generated a large amount of attention in the media. With other popular technology companies such as Groupon, Pandora, and LinkedIn going public in recent months, the IPO landscape looks similar to the dot-com days of the late 1990s. It seems that everyone wants to get their hands on a piece of the IPO pie for such high-profile companies. These “sure bets” are promoted and hyped by both the media and Wall Street insiders.

Yet while there are certainly cases of IPO stocks that do exceptionally well, for every Google or Microsoft, there are many more that underperform the overall market.

How Do Stock IPOs Actually Perform Over Time?
A study published in the Journal of Finance and quoted by financial writer Larry Swedroe examined 1,232 IPOs from 1988 to 1995 and found that 25 percent of the offerings closed the first day of trading below the offering price. The “hot” IPOs that rose 60% or more in the first day subsequently underperformed the market by 2 to 3 percent per month. Another study by finance professor Jay Ritter and quoted by Swedroe looked at 1,006 IPOs from 1988 to 1993 and found that 46% of the stocks generated a negative return.¹ Additional research by Ritter shows that IPO stocks from 1980 to 2008 underperformed the overall market by 7.1% during the first 3 years following the IPO.²

Recently, Bloomberg examined data on the biggest opening IPOs for 2010 and 2011 and found that the top 25 as a group were down 31% as of November 2nd, 2011.³ From the beginning of 2010 through the end of the same time frame, the S&P 500 was up 15.14%.⁴

When looking at performance data specifically for Groupon, Pandora, and LinkedIn, the results vary, with Pandora and Groupon significantly underperforming and LinkedIn outperforming the S&P 500 index.⁴


So Who Makes The Big Money In An IPO?
Company founders and executives, investment banks brokering the shares, venture capital funds, private equity companies, hedge funds and pension funds most often have access to shares before the public offering and can potentially do well in an IPO, depending on when they sell.

However, a major challenge for the individual investor, even if he or she wanted to invest in an IPO, is limited access. For high profile IPOs, everyone wants a piece of the pie and as a result there are limited seats at the table. Those shares that are available tend to go to large institutional investors or individuals with hundreds of millions of investable assets.

This relegates smaller individual investors to waiting for the company to be traded in the secondary market after going public rather than buying shares at the offering price. As seen in the data presented, stocks do not tend to perform well when compared with the overall market once they’ve gone public.

Individual Company Risk
With any investment, risk is a vitally important factor to evaluate. Stocks of individual companies are especially risky, no matter how promising a company’s prospects may be.

In the specific case of Facebook, its revenue comes primarily from advertising and its partnership with game maker Zynga. The impact of technologies that block ads or adverse conditions in the advertising industry represent a significant risk for Facebook. Additionally, if its relationship with Zynga were to sour, this could be a heavy blow to revenue. The impact of advertising on Facebook is still much in doubt; in fact, General Motors made a decision to stop advertising on Facebook the week of its IPO, citing a lack of impact from its Facebook advertising efforts on car sales⁵. Also, other social media competitors such as Google+ and Twitter present a market share risk if users shift loyalties to one of those platforms.

High profile IPOs make for interesting water cooler conversation topics but the prudent investor will do well to steer clear and maintain a well-diversified investment strategy.

_{¹ Swedroe, Larry; 2005; The Only Guide To A Winning Investment Strategy You’ll Ever Need; pg. 255-56.
²Ritter, Jay; 2011; “Equilibrium in the Initial Public Offering Market”; Annual Review of Financial Economics, Vol. 3 (2011).
³http://www.businessweek.com/finance/occupy-wall-street/archives/2011/11/groupon_beware_of_20_hot_ipos_20_tanked_later.html
⁴Data source: Morningstar Direct
⁵http://online.wsj.com/article/SB10001424052702304192704577406394017764460.html} 

Occasionally, the financial media reports on an investing strategy known as “The Dogs of Dow.” This strategy was first popularized in the early 1990s and involves selecting the ten stocks in the Dow Jones Industrial Average with the highest dividend yield. At the beginning of each year, the portfolio is adjusted to reflect the new set of stocks.

The name comes from the idea that companies with high dividend yields are near a low in their business cycle and that the stock price is low in comparison with the dividends being paid. This results in a high dividend yield. The theory is that the stock is undervalued and represents a buying opportunity since a company’s management would not likely pay a high dividend if it didn’t expect corresponding profits.

An example of a 2012 Dog of the Dow is AT&T. The stock price on December 30, 2011 was $30.24 and the dividend for the year was $1.76 per share. This equates to a dividend yield of 5.82%.To illustrate how dividend yields can fluctuate, if the dividend stayed the same and the stock price went up to $50, the dividend yield would be 3.52%¹.

Proponents trumpet the success of a Dogs of the Dow portfolio when it has a good year but are comparatively quiet in down years. When evaluated over the long term, a Dogs portfolio underperforms the Dow as a whole. From 1996 to2011, the Dogs returned an annualized 6.70% vs. the return of the Dow at 7.87%. Year by year, the Dogs only outperformed the overall Dow in 7 of the past 16 years, as seen in the graph below²:

Beyond performance, there are a number of other drawbacks to a Dogs of the Dow strategy, including increased trading costs, lack of diversification, and higher taxes. Higher trading costs are incurred due to buying the new Dogs stocks each year, selling the old ones, and rebalancing those retained in the portfolio. While the overall Dow is relatively well diversified, there is no certainty that a Dogs portfolio will be. This potentially exposes the portfolio to unintended risk and concentration in an industry.

From a tax perspective, there are also a couple of downsides to a Dogs of the Dow portfolio. By definition, Dogs stocks pay higher dividends than the overall Dow stocks and as a result incur greater dividend taxes. The strategy will also result in frequent capital gains taxes due to the selling of Dogs stocks that will not continue in the portfolio. Some of these will be short-term capital gains and will be taxed at the highest rate if not held from a prior year. In contrast, no annual capital gains tax would be due for a Dow portfolio held long term.

For an investment strategy to be more than just a catchy anecdote, it must be successful across a broad time horizon. While the Dogs of the Dow is a topic that the media likes to talk about, it has little validity as an investing strategy and is dismissed by academics due to data mining a specific time frame to prove a bias. Those interested in proven investment strategies will be best served to keep the Dogs of the Dow in the doghouse and instead focus on long-term wealth management rather than the flavor du jour.

¹Morningstar Direct
²www.DogsoftheDow.com (accessed January 24, 2012)