A Closer Look at the Facebook IPO

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.  

How to Avoid the Financial Slaughterhouse

One of my favorite terms in the English language comes from the world of agriculture: The “Judas cow.”

The Judas cow is a cow that lives at the slaughterhouse. The staff takes great care of the Judas cow.
Her function is to meet the other cows coming off of the cattle cars, down the ramps and into the pens outside of the slaughterhouse. From there, the Judas cow settles the other cows down, and leads them calmly into the slaughterhouse. The staff, of course, lets the Judas cow through and out the other side. The rest of the cows, naturally, become dinner and boots.

So what does this have to do with economics and finance? Well, it has to do with considering the source of information. A few weeks ago, the National Association of Realtors published a glowing, bullish report on the future of the housing market.

Of course they’re bullish! (no pun intended!) The National Association of Realtors represents the real estate industry! Specifically, they represent agents who don’t get a commission unless houses are sold. When people are optimistic, they buy houses, and drive home prices (and commissions) up.  When people are pessimistic, they tend to wait. Deals don’t close, and realtors don’t get paid. Meanwhile, house prices fall on the deals that do go through, so realtors get hit with a double whammy: Falling volumes and falling commissions.

Let’s go back a few years: The National Association of Realtors actually had a staff economist, David Lereah, who was acting as the Judas cow for real estate investors. The National Association of Realtors called him an economist. But that wasn’t his job. His real job was in PR and Marketing. His real job was to sell the dream of homeownership and real estate investing, come Hell or high water.

And Lereah was a very efficient employee for the National Association of Realtors – lending an economists’ veneer of credibility to the positive marketing spin, publishing enthusiastic, bullish reports on real estate in the mid to late 2000s, even as the wheels were coming off. His dogged adherence to the NAR party line earned him rueful comparisons to Baghdad Bob, the hapless spokesperson for the Hussein regime who comically assured news viewers that American forces were being slaughtered in the desert even as U.S. tanks were overrunning the airport in Baghdad in 2003.

Lereah was the Judas cow of the housing crisis. And when he was no longer useful to the NAR, he made an exit to head his own firm, Reecon Advisors, to be replaced at NAR by Lawrence Yun. 

Curiously, once Lereah was no longer on the NAR payroll, his analysis took a much more bearish tone. Yun, of course, has consistently maintained that now is a perfect time to invest in real estate, all through the decline.

Of course, at some point, he’s bound to be right.*

Here’s what you need to know:  Lereah was not the only Judas cow out there. The practice of dressing PR shills up as economists or “analysts” and trotting them out before the cameras is common in the financial services industry. It’s even routine. Before Lereah, there was Mary Meeker and Henry Blodget, touting Internet stocks at any price, back in 1999 and 2000, hawking these stocks to the public even as they were confiding to each other that these earnings-less Internet stocks were far, far overpriced. Before them it was biotech. Before them it was the Nifty Fifty, and radio stocks. And so it goes back to the tulip bulb bubble of the 17^th Century in Amsterdam and beyond.

These financial Judas cows are everywhere – and they regularly infest the talking head news programs on TV. And precious few journalists are equipped to see through them. (If they were any good, most of them wouldn’t be journalists for long!)

That’s why we believe strongly in the value of fee-only financial planning. At Vaerdi, we receive no compensation from any outside interest. We don’t get a higher commission for steering you in or out of any investment. We have only one obligation: To give you the best, most unbiased financial advice you can get. Our job is to help you spot the Judas cows on TV and in the print media.

 *Incidentally, if you’re wondering, we’re neutral about whether it is, or not. Most of the time, personal and local factors are a much bigger part of that equation than any national projection for real estate asset prices. Direct ownership of real estate is so property specific, and person-specific, that we take each case one at a time, and broad national projections don’t factor much into it.

Celebrity Bank Cards Attract Young Customers

I’ve been carrying around an article about celebrity bank cards from the New York Times since, well, last year, partially because the picture of the Twilight characters on a bank card amused me, but more because the sneaky tactics to get young consumers to buy this product astounded me.  While I originally thought it must be a joke, this very real product has seriously high fees–and targets young consumers (the author may think she’s a young consumer, but apparently not: imagine paying for a business lunch with a Kardashian Kard?).

Celebrity bank cards are not new, but they have not been as successful until now: current designs lure young consumers into a product without knowing the price of cool.  The price of cool, however, comes with high fees: $7.95 monthly fee, $1.50 ATM fee, $1.50 to speak with a phone representative. Want to keep up with the Kardashians? Get their bank card, spend like they do, and achieve their lifestyle. Not quite.

With the changes in consumer protections and the recent financial crisis, there have been some positive changes: many of us have become more informed consumers.  Many of us also know that people got into trouble by making uninformed decisions.  Some of us know to understand the underlying costs and read the fine print.  Few of us can escape the pressures of marketing, especially younger consumers who are entering the world as new, independent consumers.  In the case of celebrity bank cards, remind those young consumers you know to keep up with the Kardashians on TV, not through their wallets.