Social media company Facebook had their initial public offering (IPO) on Friday,May 18, 2012. An IPO is where a private company makes their shares available to the public for the first time. This well recognized company with over 1 billion worldwide users had significant hype leading up to the initial public offering. However, the early trading has left many of the initial purchasers of the company shares disappointed. It seems people continue to be fooled by the history of IPOs and their beliefs that if they can only pick the right IPO that it will help them reach their goals. Nothing can be further from the truth for the average investor.
I figured I would take the opportunity of this well publicized IPO to describe why we do not invest in the shares of initial public offerings for at least 12 months. As would be expected, especially for media hyped IPOs, demand for the shares creates pricing pressure on the stock. Stocks (like all items) that are subject to tremendous demand cost more. It is only through time that the push and pull of supply and demand eventually settles on what the markets establishes as the fair price.
When your philosophy in dealing with portfolio stock exposure – as it is here at Crimmins Wealth Management – is to be broadly diversified in the global stock markets, then one additional company added to a portfolio that already has 8,000 to 10,000 holdings is not as urgent. So, while we will add most new companies in the future to the portfolios, there is no immediate need to be subjected to the over hyped nature of any one company and thus, the patient trading insures that the stock is properly categorized.
While the noise that often surrounds IPOs is one reason that we delay purchasing them, experience also shows that the most sought-after IPOs tend not to be widely offered, while the market is flooded with stock in the less popular floats. Alongside these practical short-term issues are many studies pointing to long-run underperformance of IPOs, notwithstanding any ‘stag’ profits made by speculators who sell quickly on-market after receiving discounted stock in the offer period.
According to Jim Parker at DFA, among the most referenced papers of the subject was written by Tim Loughran and Jay Ritter, “The New Issues Puzzle” in the Journal of Finance in March 1995, which looked at IPOs issued in the preceding 25 years. During the five years after the issue, investors received average returns of only 5%. Ritter, who is considered an IPO expert, updated that data to take in the period 1980-2008 in his paper “Some Factoids About the 2009 IPO Market”. He found firms with sales below $50 million tended to make a bigger splash on debut, but underperformed their larger counterparts over three-year periods. Both smaller and larger firms underperformed average market buy-and-hold returns over three years – smaller firms by a substantial margin.
Facebook may indeed turn out to be a good investment, but this will not be determined by the level of marketing hype or by blanket media coverage but by the judgment of the market itself. And that takes time. So we will wait patiently for the judgement.