ANATOMY OF AN IPO

Initial public offerings (IPOs) are associated in investors’ minds with enormous profits. These profits, however, tend to be more for the founders of companies and for investment banks rather than for retail investors or even institutional investors. Market observers always call to mind a few “hot” IPOs where the share price provided double-digit returns in a single day.
 
But what happens after the initial excitement? Studies have shown that, in general, investors are better off owning shares of seasoned companies as opposed to new issues through an IPO. While we don’t know for sure why investors overpay for IPOs, research also indicates that investors overweight the probability of extreme growth of newly listed companies and therefore apply too high a value to these shares.*
 
That brings us to the recent Facebook IPO. We don’t know if Facebook is fairly valued or not. We generally believe that the market fairly prices liquidly traded securities and therefore we do not believe we have much edge or insight into the valuation of any one issue. Given our belief that large, liquid stocks are generally fairly priced, and because of the long-term underperformance of IPOs, as a firm, Wealth Enhancement Group did not participate in the Facebook IPO and we advised our clients against participation as well. In general, we advise against participation in any IPO.
 
Not having edge or insight into publicly traded stocks sounds like a bad thing, but it’s actually a good thing. When all market participants are working with the same information, it limits the ability of more-informed market participants to take advantage of less-informed participants, who unfortunately tend to be working savers or retirees. In the case of the Facebook IPO, there have been allegations that not every investor had the same information. According to press reports, certain investment banks changed their forecasts for Facebook and communicated those changes only to institutional clients, leaving individual investors—their retail clients—in the dark. The effect was that those retail clients may have paid more than they would have otherwise been willing to pay for the Facebook shares. While we don’t know yet what happened at Facebook, we do know that the more widely information is disseminated, the better for individual investors, our clients and the functioning of the market as a whole.
 
Wealth Enhancement Group
 
*Ritter, Jay, 1991, The long run performance of IPOs, Journal of Finance 46, 3-q7.

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