Thursday, February 23, 2012

Facebook: Playing the "IPO pop" game?

In my last post on Facebook, I provided my estimate of value (about $ 70 billion) and concluded that I would not be a buyer of Facebook shares even if the company was valued at close to $ 70 billion. A few of you have taken me to task for leaving what you see as easy profits on the table, noting that if I were able to get Facebook shares at the offering price, that I would be guaranteed (or close to guaranteed) a substantial profit. More generally, there is the perception that investing in IPOs at the offering price (and making money on the offering day pop) is a low-risk, high return strategy that can be used to augment your portfolio returns. Like most "sure" things in investing, this one comes with implicit assumptions and costs and is definitely not "sure". Here is my list of caveats for those considering the "Facebook IPO Pop" strategy.

1. You have to be able to get the shares at the offering price
Let's say that when the Facebook IPO does get "priced", you bid to buy shares at the offering price. One of two things will happen: you will either get your requested number of shares or you will not, and ironically, it is the former that should worry you. If you are right in your basic hypothesis, i.e., that IPOs are under priced, the demand for the shares at the offering price will exceed the supply and the investment bankers managing the IPO will have to ration the shares. If the process is fair, you should get only a proportion of the shares you asked for, with the proportion getting smaller as the shares get more under priced. If the process is fixed and the investment banks give first dibs to their preferred customers, the proportion you get, if you are not one of the preferred customers, will be even lower. Thus, the only scenario you should dread if you are not a preferred customer is one where you get your entire allotment filled, because that is an indication that the shares are over priced.

This allotment process has always been the achilles heel of strategies that try to invest across all IPO offerings. You may bid for $100,000 worth of shares of every IPO for the next year, but you will end up with a portfolio that has too little invested in the most under priced IPOs (since you will get far fewer shares than you requested in these) and too much in the most over priced IPOs (since you will get all of the shares you asked for with these).

2. The stock has to pop on the offering date
Once you have been allotted the shares at the offering price, you have to hope for a stock price pop on the offering date. You do have history on your side. Looking across all IPOs, there is evidence of an offering day increase in stock prices. The figure below graphs out the average "under pricing" across all IPOs, by year, for US stocks:

Note, though, that this return presupposes that you can invest an equal amount in each IPO, under priced or not, but it is still impressive. Over the entire 50 year time period, there have been only four years (1962, 1973-1975) where the average returns were negative, and there are periods, such as the late 1990s, where the average return is close to 100% (doubling of price on the offering date). That is good news for the "Facebook IPO Pop" strategy.

Before you get too excited, though, note that the under pricing is greatest with the smallest offerings, as evidenced in the graph below:

Given the size of the Facebook offering (even 5% of $100 billion makes this a big offering), this graph should lead you to lower your expectations of the price pop on the offering date.

There is also evidence that this under pricing is by design. The IPO pricing cookbook at most investment banks includes a "take 15% off the value" ingredient in every pricing recipe, since the positive news stories that accompany the pop are viewed as a sales pitch for future stock issues. The under pricing also is consistent with the incentives for investment banks, who generally guarantee the offering price to the issuers, and thus have fare more to lose by over pricing than from under pricing.

This IPO under pricing has been the source of angst for some, who feel that the under pricing is unfair to the founders/owners of the company going public, since they are leaving money on the table, by offering their shares at a discounted price. That argument, though, becomes less persuasive, when you recognize that only a small portion of the outstanding shares is generally offered on the offering date. The discounted price on these shares operates the same way a loss leader operates in a retail store: it is designed to whet your appetite and get you to buy more. You hope that those who buy these shares (and feel good about the profits they make) will be back in six months or a year to buy more shares in the company. So, if you are feeling sorry for poor Mark Zuckerberg on the offering date, don't worry! There are plenty more shares in Facebook that will be hitting the market in future years.

From an investor's perspective, what can go wrong? Note that the average is across all IPOs (and is skewed by the smallest IPOs) and that a subset of IPOs see a drop in price on the offering date. These are of course the IPOs where you got all of the shares you asked for. If you are not a preferred customer, your odds of making money on IPOs decrease. Even the preferred customers are offered a mixed bag. Not only does their preference stem from the large amounts that they pay the investment banks for other services rendered, but they are expected to be "good" investors. In other words, if they flip the stock soon after the offering, it may endanger their preferred status on future IPOs. More on that in the next section!

3. You have to time your exit well
Assume now that the first two pieces of the puzzle have fallen into place. You have been allotted shares in the Facebook IPO and the stock has popped 15% on the offering date. Should you sell now or should you wait? That eternal  question has particular resonance with IPOs, because the gains on the offering date can be fleeting. Remember that Groupon's 20% jump on the offering date is now all gone!

Studies that track the post-offering performance of IPOs suggest that they do are not good investments in the aftermath. In the figure below, we compare the returns in the first five years after an initial public offering, with the returns on non-IPO stocks.

The returns on IPOs lag the returns on other stocks in the market and do so much more in the first few years after the offering. Thus, if buying at the offering price requires you to hold the stock for a year or two (which may be required of you as a preferred customer), you may not be getting a great deal.

In fact, my valuation of Facebook is predicated on the assumption that you may want to hold Facebook for more than a day in your portfolio. If you do, once the buzz fades and the IPO paparazzi leave, the company will be judged increasingly by how it performs relative to expectations. If price and value are on a collision course, value always wins out.

4. You are playing a sector and momentum game, even if you don't want to...
If you bid for shares in the Facebook IPO offering, I do believe that the odds may be in your favor for winning the game, if you define winning as getting the shares at the offering price and flipping them very quickly after the IPO. Much as I am tempted to join you, I am afraid I will sit out that game and not because of any noble impulses (such as wanting to be a long term investor or not speculating).

The IPO game is a subset of the momentum game, on which I have posted before. It is a game that produces big winners but momentum always turns, and when it does, it creates big losers. To see the link, note that IPOs go through hot and cold phases, with years in which you have hundreds of IPOs and years in which you have a few dozen.

In addition, also note that IPOs in any given year tend to be concentrated in a few sectors and those sectors generally have momentum on their side (dot com stocks in the 1990s, social media companies today). Thus, the success of IPOs in a sector is closely tied to whether the sector maintains it "hot" status.

One worrisome aspect of IPOs is that they may operate as canaries in the coal mine in signaling momentum shifts; the loss of enthusiasm for dot com IPOs (and the withdrawals of some) coincided with the epic collapse of the sector that year. The momentum driving social media companies will end one day and it may very well be the day that Facebook goes public. "Unlikely", you say, and I agree, but the tough part of being a lemming is that you never know where the cliff is coming. Of course, you may be able to sense momentum change much better than I, in which case you should be able to play the game successfully.

Bottom line
A strategy of investing in IPOs at the offering price looks much better on paper than it works in practice. All of the academic studies that show the average underpricing are implicitly based upon the assumption that you can create an equally weighted portfolio of all IPOs, when in fact, a non-discriminating investor will end up  will be with too much invested in all of the worst IPOs.

The strategy can be made to work by an investor who uses analysis (valuation or information) to invest only in IPOs that are most likely to be under priced and follows through with timely selling to capture profits after the offering. Even for that investor, it is a supplementary strategy since there will extended periods where there are no or very few IPOs in the market.

So, if you are bidding for those Facebook shares, good luck. I hope you get only a fraction of the shares you ask for (see part 1 for why), that the stock price pops on the offering date, that you get out before the you-know-what hits the fan. and that you are not the unfortunate soul who helps ring in the end of the social media circus.

14 comments:

Loganthan said...

World over subscribing to IPO's is akin to playing the lotto. Today in India the IPO of a commodity exchange was oversubscribed 43 times! My view is why the rush - all companies will at some point be undervalued by the market (Amazon I am sure has offered umpteen entry points over the last decade) and patiently tracking the stock will most likely offer good entry points with the added benefits of the froth being taken out, history of performance, and you can buy the quantity you want instead of having to settle for a small fraction of what you applied for. One may get a better percentage gain on an IPO pop but the bigger dollar value of gains I think will come from investing later.

Andrew F said...

I've always wondered why IPOs work the way they do. They make little sense game theoretically. A k-th price auction, or just about any kind of auction, would make more sense for the issuer.

Unless IPOs are not about raising equity efficiently, but are more about generating buzz about the company. I don't get them, and I don't trust IPOs.

Aswath Damodaran said...

Andrew,
Google did do an auction, but they are the exception. And I think you have nailed the reason why we should not make too much of the pricing of an IPO. It is a kabuki dance, designed to distract and enchant you... and soften you up for future sales pitches.

shlomi ardan said...

Great post professor,

One thing you should know though,regarding the lemming allegory you use in valuation- lemmings don't really commit suicide..

In the disney film that originated the myth, they actually trapped and scared them into falling deliberately. Disney can get quite crazy sometime.

http://www.youtube.com/watch?v=pDqlZjpSJCc

Hope this clears a bit of the lemmings' reputation, but I do admit, as they say in the clip above- "without lemmings there would be a lemming shaped hole in the public discourse" :)

Pranav Pratap Singh said...

Looking for the Uncle who smirked at me commenting "you are an mba in finance and don't put money in ipos to flip them on the first day!!!". Want to show him the post.

pth said...

Professor, I wonder how you define “average return on offering date” (see exhibit 1) and “average initial return” (see exhibit 2). Thanks a lot in advance. Peter

Anonymous said...

Uh, great theory, prof, but you forgot one thing. You need to specifically address the Facebook IPO on its own. If an investor thinks Facebook is the Google of social media, just buy the danged IPO and stop worrying. Look at the global reach of Facebook which has barely scratched the surface.
Why the rush? Well, the buzz and if you compare to Google (another co. that started where people wondered how the heck can this entity even make money?) I'd say get yourself some Facebook stock somewhere along the line as part of an overall portfolio.
Basically, this prof is overanalyzing the entire IPO market much like "experts" do comparing ETFs to mutual funds. You have to look at each stock on its own within that overall framework. Holy smokers, the lesson on IPOs was unnecessary. All that has been done elsewhere. Give us some real analysis of Facebook's IPO not the entire IP) market.

Aswath Damodaran said...

I thought that is what I did on my previous post, when I valued Facebook in detail. I am not sure what exactly you would do that was specific to Facebook for the IPO. Once you have the value, all you are doing is playing the IPO game.

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Andy said...

Prof. Damodaran,

How about trying to play the "pop" game a different way. Say Facebook shares open at $30 /share and pop to $45. When they hit $45 I buy put options with a strike at $35 that expire in 300 days.

Presumably, the stock will pull back from the pop (as usually is the case) in the weeks or months after the IPO. Once the stock falls back to earth I exit my position for a tidy profit. If I view the stock as over-valued, wouldn't this be a relatively safe way to bet that the "pop" is only temporary?

Thanks for your insights!

Anirudh said...

Hi Professor,

I'd be interested in knowing your response to the above posted question...

thanks,

Anirudh

Denial Paul said...

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QUALITY STOCKS UNDER 5 DOLLARS said...

Facebook is a classic example of a pure pump and dump scheme.

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