Tech Selloff Underscores Dangers Of IPOs

This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.

Earlier this year stocks in the technology sector fell, wiping out billions of dollars in shareholder value. In particular stocks which had a relatively recent Initial Public Offering (IPO) fell much harder than other names. The selloff was a reminder of the dangers of IPOs which tend to be heavily-promoted “story stocks” with questionable valuation metrics.

For instance, Twitter fell 18% in one day, eventually shedding some 50% of its value. FireEye fell 24% in one day and eventually lost 72% of its initial value. Other relatively recent IPOs notably affected included Nimble Storage, Rackspace Hosting and Splunk .

This is not to pick on technology, in fact IPOs in general perform poorly.

The research has shown that people overpay for stocks they hear about in the news.

Jay Ritter in The Journal Of Finance article “The Long-Run Performance of Initial Public Offerings,” finds that three years after an IPO, most new companies were significantly underperforming a set of comparable firms matched by size and industry.

Ritter covers the “hot issue” phenomenon and the fact that investors overwhelmingly buy in when the stocks are overpriced. The results were the same for Ang, Gu and Hochberg as described in their paper for the Journal of Financial and Quantitative Analysis. Their conclusion in two words: Avoid IPOs.

First, because IPO’s are often “story stocks.” Many IPO’s are talked about extensively before they come to market. The investor sees and hears the story behind the company everywhere. But a good story and enthusiastic promotion by various commentators doesn’t guarantee a good stock.

Second, often the story behind the stock builds its premise on questionable valuation. All that hype can mask the fact that the stocks simply don’t have the fundamentals, aren’t profitable and won’t provide value in the long run.

For example, many pointed to the fact that these IPOs had a good deal of cash on hand in contrast to the cash-poor IPOs of 1999-2000 which ended up failing. A Wall Street Journal analysis concluded that none of the recent IPO tech companies would burn through their cash within a year, based on their pace of spending in 2013. In other words, they had enough cash to support operations for a year, which could not be said of many Dot-Com-era IPOs.

Cash, however, is not king. Simply measuring cash on hand or cash burn ratios does not provide enough information to determine a company’s health. In short, it’s hard to top the traditional metrics — namely price/earnings (P/E) ratios — by zeroing in on a single favorable item on the balance sheet such as cash.

Jeremy Siegel a finance professor at the University of Pennsylvania’s Wharton School wrote a piece for The Wall Street Journal in early 2000 just as tech stocks were peaking. In the article, he cautioned: “History has shown that whenever companies, no matter how great, get priced above 50 to 60 times earnings (P/E), buyer beware.”

The long-term average forward price-to-earnings multiple, as measured on the S&P 500 is now around 15. This means that a stock is trading at a price of $15 a share and analysts think it will have earnings of $1 in the upcoming 12 months. The P/E’s for many of the IPO stocks that corrected had been 10 to 20 times that or more.

Way Forward

The way forward is simply don’t get caught up in hype. Buy based on a strategy using fundamental analysis (including considering traditional metrics like price/earnings ratios), value or momentum profitability. Never buy a specific stock just because you think you can make money on it.

And, be particularly wary of IPOs. As recent events have shown, people who buy into IPOs can find they have invested in companies that are priced way past their valuations. When they settle (or correct) they take a lot of hopeful investors’ money with them.

Disclosure: I do not own shares of the equities mentioned in this article. 

Click here to see the article on Forbes.

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