Sincerely, I “Like” Facebook
$ ?s answered by Matthew Illian, CFP®
Some will believe that you need some combination of unscrupulous greed and/or blind luck to make money in the financial markets. It turns out that you just need to avoid making big mistakes and buying into IPOs is one of them. Study after study reveals that IPOs perform poorly in the first year (or longer) after their offering both in the United States and abroad.
Despite some of the highly publicized glitches, Facebook’s (ticker: FB) initial public offering (IPO) was the third biggest of all time in terms of money raised and has caught the attention of the investing world. Prudent investors will avoid IPOs and wait for the dust to settle before making a buying decision.
Huge financial incentives motivate a newly minted public stock to attempt to keep their best foot forward just long enough for the early investors (including original owners and venture capital investors) to maximize their profits. It is well documented that reported revenues typically fall in the year after an IPO. Understanding these incentives can help explain the historical trend of underperformance in the first year after a public offering.
IPO markets do not operate like the rest of the stock market in their first days and weeks of trading. In typical markets, buyers and sellers are independently deciding to buy and sell their stock. In the case of IPOs, there is typically a backstop to make sure the trading price never falls below the offer price.
This price stabilization is provided by an agreement between the company and their lead underwriters. These underwriters are large banks (Morgan Stanley was the biggest in the Facebook IPO) that agree to sell large amounts of stock every time the price begins to drop to the offer price.
Watching the FB IPO was an interesting case study in how the underwriters work behind the scenes to support a stock price. FB had its initial offering price set at $38, and Morgan Stanley made a commitment to purchase shares to keep the price of FB at or above $38. You can see the effect of this powerful buyer by watching how the price seems to skip off $38 around 11:30 am and then again at 12:30 pm and 3 pm before finally settling at down at $38 but never going lower.
Many believe the underwriters have used up all of their capacity to support the price of the stock, which is why it is now moving below the $38 mark.
A second round of downward pressure will come when the lockup period ends for a large block of investors. The lockup period typically last for 180 days after an offering in which certain shares are restricted from being sold.
Facebook reveals this pressure in their own SEC filing, “substantial blocks of our total outstanding shares may be sold into the market when ‘lockup’ or ‘market standoff’ periods end. . . . If there are substantial sales of shares of our common stock, the price of our Class A common stock could decline.”
A final reason to avoid IPO stocks is because you are typically buying into the worst performing style box available to investors. Unlike the gargantuan Facebook IPO, most IPOs begin their listing at what Morningstar defines as small growth companies. Historical underperformance of smaller growth companies is well documented in the Fama French four-factor model. Investor euphoria over smaller companies seems to shield investors from observing that they are hopping onto the roller coaster at a precipice.
If you do decide to buy FB, history suggests at least waiting until after the lockup period expires on August 20, 2012.
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