Why IPOs are a lousy bet

It's all about rarity of shares.

By Motley Fool Pick of the Day Feb 7, 2012 2:41PM

By Dan Caplinger

 

I never thought that one of my guilty pleasures would give me investing insight. But something I learned watching a home shopping channel showed me why buying into initial public offerings makes less sense than ever right now.

 

I'll share that insight later in this article. But first, I want to give some perspective on where the IPO market stands right now.

 

IPOs are back!
After a several-year hiatus in which we saw relatively few IPOs of any magnitude, initial public offerings are back in vogue. Facebook's IPO announcement last week was just the latest in a big series of companies going public, and you can expect far more IPOs to come if the stock market continues performing well.

 

But just because IPOs are getting more numerous doesn't mean they're a smart investment. It used to be that going public was a great accomplishment that marked a pinnacle of success for a company. But now, the IPO process is increasingly about prestige and exclusivity rather than actually putting a legitimate price on a company's value -- and IPO investors are the ones who'll suffer in the long run.

 

What I learned from home shopping
When I channel-surf, I often get stuck on a shopping channel, especially when they're selling coin sets. I like coins, but what draws me to the program is how they market them. The announcer always makes it clear that a coin is part of a relatively small set available, that quantities are limited, and that you should therefore buy now before they're all gone. That rarity is seen as a mark of potential price appreciation for the future.

 

What does that have to do with investing? Companies going public have taken a page from the home shopping channel and borrowed the same marketing strategy -- turning IPOs into limited-edition stock offerings. But there's a catch that can burn you in the long run.

 

Get your red-hot shares now!
In particular, companies are offering tiny amounts of their overall stock. Even though Facebook's $5 billion offering will dwarf other tech IPOs, it will still represent only 5% of the total shares outstanding. That's become commonplace among tech companies; Groupon (GRPN) only offered 6.3% of its outstanding shares in its IPO -- the lowest stake for an IPO in the past decade -- while LinkedIn (LNKD) came in at 8.3%. Those stakes are far less than the 20% to 25% that are more typical for an initial public offering.

 

Several analysts at the time pointed out that the scarcity value contributed to high valuations -- valuations that for Groupon and LinkedIn soared during the first hours of trading but then quickly led to big price declines for the companies involved. And interestingly, it's not a strategy that every tech company is following. Zynga (ZNGA), for instance, offered nearly 15% of its shares in its IPO -- a move that some blamed for the company's failure to jump on its IPO day.

 

But now you're starting to see the trend move beyond tech. Casino company Caesars Entertainment is planning a tiny offering of just 1.8 million shares worth about $16 million. That apparently may not include amounts that selling shareholders may add to the offering, but at least as the prospectus reads today, it represents only 1.5% of the total shares outstanding.

 

IPOs shouldn't be collectors' items
The problem comes when lock-up agreements expire, allowing investors to sell more shares onto the open market. For instance, Pandora (P) came out of the gate with a roar at its June IPO, with shares trading as high as $26 before settling at an opening-day close of $17.42. But by the time locked-up shares became available six months later, the shares were down to around $10. Battery-tech company A123 Systems (AONE) saw a similar plunge on the day its lock-up period ended.

 

IPO investors need to realize that companies understand supply and demand, and that low-float offerings are designed to make investors pay too much for shares. Don't let share scarcity scare you into overpaying, or else you'll end up with an investment that you can't just return to the shopping channel.

 

Fool contributor Dan Caplinger bought IPO shares once, but it didn't turn out the way he'd hoped. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of LinkedIn. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool's disclosure policy will never go out of style.

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