Category: Investing

Do you think you can make lots of money by getting in on the ground floor of the initial public offering of a company just coming to market?

IPO stands for Initial Public Offering – it’s the first sale of a new issue of company’s stock to the public.

Only when we purchase shares at an IPO we are providing capital for:

• the acquisition of personnel,
• plant,
• and equipment.

Only then are we truly investing. Most of the time, we are buying and selling shares in the “secondary market”; the company usually has no interest in the flow of funds, since such activity does not directly impact it.

Warren Buffett believes that an intelligent investor in common stocks will do better in the secondary market than he will do buying new issues.

The reason has to do with the way prices are set in each instance.  The secondary market, which is periodically ruled by mass folly, is constantly setting a “clearing” price.  No matter how foolish that price may be, it’s what counts for the holder of a stock or bond who needs (forced sellers) or wishes to sell. There are always going to be a few such holders at any moment.  In many instances, shares worth x in business value have sold in the market for 1/2x or less.

Good illustration to that point is the bear market of 1974-1975. By the end of 1974, the average stock sold at seven times earnings (average P/E = 7).

Buffett says that the new-issue (IPO) market, on the other hand, is ruled by controlling stockholders (insiders) and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether.  Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction:  It’s rare you’ll find x for 1/2x here.  Indeed, in the case of common-stock offerings, selling shareholders are often motivated to unload only when they feel the market is overpaying.

Remember that the major sellers of the stock of IPOs are the managers of the companies themselves. They try to time their sales to coincide with a peak in the prosperity of their companies or with the height of investor enthusiasm. In such cases, the urge to get on the bandwagon – even in high-growth industries – produced a profitless prosperity for investors.

Buffett recommends to avoid new issues – the insiders are selling their company, so it’s ridiculous to think that an IPO will be the cheapest thing to buy in a world of thousands of stocks. The IPO sellers pick the time to sell. So don’t waste five seconds on it.

Most new issues are sold under “favorable market conditions” – which means favorable for the seller and consequently less favorable for the buyer. Academic research has shown that corporations choose to offer new shares to the public when the stock market is near a peak. There is a general tendency to sell new securities of all types when conditions are most favorable to the issuer.

There are supply limitations on a hot IPO market.

The typical IPO buyer looks for a short-term price spurt arising from a combination of hype and scarcity. Buffett noted that on many initial public offerings, Wall Street firms intentionally limit supply, so the stock has a big first-day pop, creating a “hot issue”. However, that just means Wall Street’s favorite clients (IPO underwriters), not the company, are getting the enormous benefits of a hot IPO market.

There is also a Build-in commission of 7% on average.

New issues have special salesmanship behind them, which calls therefore for a special degree of sales resistance. IPOs normally are sold with an “underwriting discount” which is a built-in commission of 7% on average.

Charlie Munger said to avoid issues with a large commission attached. Instead, look at things other smart people are buying. Like for example businesses that top value investors are buying into.

The poor performance of IPO companies starts about six months after the issue is sold. Six months is generally set as the “lock-up” (or escrow) period, where insiders are prohibited from selling stock to the public. Once that constraint is lifted, the price of the stock often tanks.

All the reasons mentioned above come down to IPOs being very expensive.

IPOs flagrantly violate one of Benjamin Graham’s most fundamental investing rules, namely:

No matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.

Why people gravitate toward buying an IPO?

In fact, one of the deadliest investment traits is the need for excitement. People gravitate towards low-probability and high-payoff bets. For example, it’s well known among professional horse race bettors that it is much easier to make money on favorites than on long shots. The reason is that the amateurs tend to prefer long shots, making the odds for the remaining favorites more advantageous than they should be. It is much more exciting to bet at fifty-to-one than at two-to-five.

On more obvious level, why does anyone buy a lottery ticket when the average payoff is about fifty cents on a dollar? The same thing happens in the investment world, where small, long shot companies attract too much capital, leaving less capital for duller, more established companies. This depresses the prices of the more established companies and increases their returns.

Conclusion

Some of these issues may prove excellent buys – a few years later, when nobody wants them, and they can be had at small fraction of their true worth.

If the prospects for a given IPO are so phenomenal, then it will be a fine investment next year and the year after that. Why not put off buying the stock until later, when the company has established a record? Wait for the earnings. You can get tenbaggers in companies that have already proven themselves. When in doubt, tune in later.

Often with the exciting long shots the pressure builds to buy at the initial public offering or else you’re too late. This is rarely true, although there are some cases where the early buying surge brings fantastic profits in a single day.

IPOs of brand-new enterprises are very risky because there’s so little to go on.

Peter Lynch has done better with IPOs of companies that have been spun out of other companies, or in related situations where the new entity actually has a track record. These were established businesses already, and you could research them the same way you research Ford or Coca-Cola.

Benjamin Graham in his book, The Intelligent Investor recommends that all investors should be wary of purchasing today’s hot new issues. Most initial public offerings underperform the stock market as a whole. And if you buy the new issue right after it begins trading, usually at a higher price, you are even more certain to lose.

Weighing the evidence objectively, the intelligent investor should conclude that IPO does not stand only for “initial public offering”. More accurately, it is also shorthand for:

• It’s probably overpriced
• Imaginary profits only or
• Insiders’ private Opportunity

There is no strategy I am aware of likely to lose you more money than buying IPOs, except perhaps the horse races or the gaming tables of Las Vegas.

Sources:

The Intelligent Investor – Benjamin Graham

One Up On Wall Street – Peter Lynch

4 Pillars of Investing – William Bernstein

Letters to shareholders of Berkshire Hathaway – Warren Buffett

University of Berkshire Hathaway – Daniel Pecaut, Cory Wrenn