5 Reasons Why Investors Should Forget About The Facebook IPO

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With Facebook having finally announced plans for its long anticipated IPO this spring, speculation is already rife about the social network’s likely gigantic valuation and how the shares will go on to perform. For investors with anything short of many millions of dollars to invest, the circus surrounding what is expected to be the largest ever tech IPO will be one to watch rather than partake in. But even assuming we all had the money and the invite, should the prospect of diving in to the hottest ever IPO be an attractive option

Despite the fact that CEO Mark Zuckerberg has yet to name his price – will he aim for a $100bn valuation? – the Facebook IPO has already been analysed from every angle. On one hand, commentators have muttered concerns about Zuckerberg’s letter to prospective investors (too wishy-washy), they’ve raised fears about a flood of advertising damaging user loyalty, and even questioned why the company is floating and raising money at all (when it could conceivably get away without doing either). 

Supporters may claim that Facebook’s best years are almost certainly ahead of it and, with 500 investors on the books, Facebook was already facing statutory reporting requirements, so why not squeeze some cash out of the situation? Likewise, Zuckerberg clearly has lofty ambitions, and a mega-fundraising is going to give him all the comfort he needs to achieve them. 

But as regular readers will know, rather than chasing speculative story stocks, we believe in an evidence-based approach to investing that avoids falling foul of our innate behavioural biases. So what does the empirical research say about IPO investing? Well, to get the pulse racing, it’s true that there is a mountain of research suggesting that a heady mix of behavioural finance and asymmetric information causes many flotations to get away at artificially low prices. The immediate consequence is often a first-day trading spike that makes a mint for anyone lucky enough to be holding the shares – particularly if they choose to ‘flip’, or sell them, for a profit. For investors thinking of buying shares in the aftermarket, of course, that means the Facebook IPO should be treated with extreme caution.

More generally, though, the research suggests that flotations of all sizes should carry a health warning and Facebook is no different, notwithstanding the frenzy of media attention and noise from analysts and commentators. Here’s why: 

1. Small issues for big bucks equals frothy valuations

Speculation that Facebook with raise between $5bn-$10bn against a valuation of between $75bn-$100bn means that a relatively small amount of stock is about to find its way into the market. A possible consequence will be a shortage of supply, which will drive up the share price. So anyone trading in the aftermarket is likely to be buying shares at a premium that reflects surging demand rather than Facebook’s intrinsic value

2. IPOs underperform in the short and long term

That means that anyone buying shares in the aftermath of an IPO has the odds stacked against them. US academics Loughran and Ritter produced a seminal paper in 1995 which found that IPOs typically produced returns of just 5% over five years for investors – and that this was mainly down to a ‘valuation problem’ caused by a lack of financial information about the company in question. And on that point… 

3. Limited financial information about a stock puts investors at a disadvantage

Facebook has already disappointed a few analysts, with revenues last year of $3.71 billion looking a little light against some expectations. Concerns about how an advertising ramp-up might affect user loyalty is a concern, as are spiralling Ramp;D costs up from $9 million to $114 million in 2011. However, these numbers are close to meaningless – like many IPOs, without detailed historical data (which probably doesn’t exist anyway) there is no way of getting a fix on Facebook’s valuation or its growth prospects. 

4. Winner’s curse is a perennial problem for smaller investors

Everyone will want Facebook shares, meaning that relatively unsophisticated investors will be crowded out by in-the-know investors with more knowledge than everyone else. This theory was proposed in a 1985 research paper by then Harvard professor Kevin Rock, who found that the private buyer typically ends up with little or nothing except the misery of watching more connected operators cash in. But in the case of Facebook this is all hypothetical because… 

5. Buying shares at the IPO price will be more or less impossible

When it comes to mega company flotations, private investors aren’t really part of the equation. Unless you have a client account at the bank in question (Goldman, Morgan Stanley), are an active, cash-rich and reliable share buyer or you have an ETF that buys IPOs, then the options are limited. Obviously, investors have access to the aftermarket (and many institutions that buy pre-IPO also commit to buying further shares after the introduction) but by then the excitement could be all over and you’ll be on the receiving end of a quick flip. 

Conclusion

Of course, all of these points could have been made about the Google IPO back in 2004 and the stock has quintupled since then! It’s entirely possible that this will happen again. But investing is a numbers game – it’s about having a rational, disciplined and time-tested process (be that growth investing, value investing or income investing) and not just speculating on chance outcomes. And the weight of research suggests that IPO investing is not a good idea, unless you are in a privileged position and willing to make a quick flip. The evidence suggests that patient, long-term investors trading their precious capital are much better investing in, say, a basket of ignored bargain stocks, than chasing the latest hot IPO! 

As Benjamin Graham wrote in the investing tome, Security Analysis, it’s important to distinguish investing from speculation:

“An investment operation is one which, upon thorough analysis, promises safety of principal and an adequate return. Operations not meeting these requirements are speculative”. 

If a potential IPO investor can derive an intrinsic value of $100 billion (or preferably $150 billion for Facebook – assuming a 33% margin of safety) based on some realistic set of forecast assumptions (here’s one interesting but ultimately unsuccessful attempt by blogger, MetaSD based on this research), then… good luck to them! Otherwise we should just call it what it looks like – gambling on a greater fool being out there, but not investing.

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