Well, that didn’t take long. Facebook had a nice opening day for its initial public offering (minus some execution glitches when the matching engine computer that runs the Nasdaq started to overheat). But the stock required some massive investment bank intervention to avoid fizzling out on Friday, Facebook’s first trading day.
The stock then flamed out on Monday, closing down 11 percent from the opening price. Yay.
It seems that the investment bankers pricing the shares substantially overvalued the company. Zuckerberg and the existing shareholders managed to make out just fine – selling out a big chunk of the company at a very good price (just days, incidentally, before GM announced its Facebook ads weren’t profitable).
Well, why do companies go public? Given the substantial expenses in going public and keeping your stock in circulation on a major exchange, there have to be some very good reasons. The best reason is this: The company needs to raise capital to expand. Its management believes they can invest the capital at greater than market rates of return, even after paying 7 percent off the top to the investment bankers selling the shares. And that this 7 percent commission is more efficient and reliable than borrowing the money.
Well, borrowing money is cheap these days – and Facebook has such great prospects, it shouldn’t have much trouble raising debt financing at, say, 6 percent. (That 6 percent interest payment, incidentally, is tax deductible. Dividends it may eventually pay to shareholders are not tax deductible.)
The nice thing about equity financing, though, is that debt free companies are unlikely to ever declare bankruptcy.
If you’re an insider, and you’re young (Zuckerberg isn’t hitting retirement age very soon), and you’re supremely confident about the prospects of the company, though, you don’t go public. You keep it private, and raise what you need to expand via the bond markets. Your investments pay off, you pay back the bonds and interest and keep everything else free and clear.
If you feel your prospects getting shaky, that’s when you sell off a bunch of equity to strangers and cash out.
Another tell: Facebook’s opening was on a Friday. That’s the day companies and governments release bad news – hoping that events over the weekend will distract the news commentators before the public comes back from the beaches and fishing trips.
I’m distrustful of IPOs generally, because of the natural temptation of management to dilute its holdings just as things get difficult. But I’m especially distrustful of Friday IPOs.
And I’m distrustful of stockbrokers and their managers. Here’s why: The investment bankers did everything they could to whip up demand among small accounts, offering “teaser shares” and allotments. They created an artificial shortage, and then they had brokers calling their small clients, offering a very small number of shares. Here’s the trick: Small orders are very expensive and inefficient to process for the customer. They are a gold mine for the broker dealer firm, which charges high commissions on small orders, on a percentage basis, compared to large ones.
The whole operation was designed to shear sheep.
This, indeed, was the most shameless shearing I’ve seen since the collapse of the Internet bubble in 2000.
IPOs, historically, have been a disaster for the small investor.
This isn’t new: A 1992 study from the University Illinois found that the 18 out of 21 cases, IPOs trailed the Nasdaq’s returns. The vast majority of the IPOs in the late 1990s proved to be disasters when the dot-com bubble burst. And lots of companies pointedly didn’t go public for years after that point, because of broad public disaffection with the stock market (and the atrocious behavior of stock promoters and the terrible performance by the financial media during that period of time.)
If IPOs were really priced fairly, you would expect them to roughly track the performance of the stock market over time. But look at the following chart:
This chart compares the performance of the Bloomberg IPO index against the S&P 500 index over the last year. The Bloomberg IPO index – represented by the blue line – replicates the performance of a portfolio of IPOs for 1 year after they begin trading. The S&P has been relatively flat; IPOs lost 26 percent over the last 12 months. (The Bloomberg website doesn’t allow for longer comparisons)
What’s that, you say? It’s not fair to compare IPOs against the S&P, which is all small caps? Ok. The Russell 2000 index of small cap U.S. stocks lost 6 percent over the last 12 months. IPOs, as the famous Gordon Gekko character from Wall Street would say, have been dogs with fleas.
That’s not saying IPOs are bad things, at all. Public companies have to go public somehow. But IPOs are clearly a game for experienced, professional investors with gimlet eyes and access to detailed information from vendors, competitors, industry data, and who have been able to question the fund management in considerable detail. They can then make a large buy, and do so efficiently. They frequently negotiate a discount for themselves and their direct investors – as opposed to their stock purchasing customers. There’s a difference. Just because you have an account with Morgan Stanley – the underwriter of the Facebook IPO – that doesn’t doesn’t mean you’re a part owner of Morgan Stanley.
Some IPOs work out great for everyone, no doubt. Some IPOs will struggle for a year or two or five before hitting their stride. They won’t show up in the Bloomberg IPO index.
But IPOs are not a game for the small retail investor. The company management is selling shares for a reason – and it is just too hard for the retail trader to separate the marketing and promotional froth from the real value of the company.