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).
4Data source: Morningstar Direct
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