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Sunday, June 19, 2016

IPO: It's Probably Overpriced

Today while reading the book "The Intelligent Investor", it reminded me of the core of investing and the need to filter the noises. 

But I think the story regarding IPO just struck me more than the rest today. For those who have no idea what IPO is, it means "initial public offering", or the first sales of a company's stocks to the public.

Looking at one of my favourite company, Microsoft, one could find great reasons to invest in IPO.....because if you'd bought 100 shares of Microsoft when it went on public on March 13, 1986, your $2,100 investment would have grown to $720,000 by early 2003. 

According to the book, finance professors Jay Ritter and William Schwert have shown that if one had a spread a total of only $1,000 across every IPO in January 1960, at its offering price, sold out at the end of the month, then invested anew in each successive month's crop of IPOs, the portfolio would have been worth more than $533 decillion by year end 2001. If I were to write it here's the number: 533,000,000,000,000,000,000,000,000,000,000,000. Yup. I even have trouble writing the number. That sounds like a too good to be true deal and the sad truth is that it is. 

Because for every IPO like Microsoft, there are thousands of losers. 

I think the book best sums it in this particular paragraph:

We all want to buy "the next Microsoft" - precisely because we know we missed buying the first Microsoft. But we conveniently overlook the fact that most other IPOs were terrible investments. You have could have earned that $533 decillion gain only if you never missed a single one of the IPO market's rare winners, a practical impossibility.

Of course, another disadvantage with IPO is that it's normally captured by the exclusive private group, the big boys, the big investment banks and fund houses that get shares at the initial price. (underwriting price) before the stock begins public trading. Most small time investors like you and I are likely not to get any shares, there just aren't enough to go around. And if an individual were to obtain the IPOs only after their shares have rocketed above the exclusive initial price, chances are that the return will be quite terrible. 

From 1980 through 2001, if you had bought the average IPO at its first public closing price and held on for three years, you would have underperformed the market by more than 23% points annually. 

VA LINUX, "the next Microsoft" myth

The story of VA Linux best summarize the IPO's experience. On December 9, 1999, the stock was placed at an initial public offering price of $30. 

Guess what, none of the initial owners of VA Linux would let go of any shares until the price hit $299. The stock peacked at $320 and closed at $239.25, a gain of 697.5% in a single day. But most likely, those who make the gains are the handful of institutional traders. 

After going up like a bottle rocket on the first day of trading, VA Linux came down like a buttered brick. By December 9, 2002, VA Linux closed at $1.19 per share. 

I took a photo from the chart in the book.

In no ways am I saying that all IPOs will lead to losses but I guess it all goes back to one of Graham's most fundamental rules: No matter how many other people want to buy a stock, you should buy only if the stock is a cheap way to own a desirable business.

Back to the story of VA Linux:

At the peak price of day one, investors were valuing VA Linux's shares at $12.7 billion while the company had sold a cumulative total of $44 million worth of its software and services, but had lost $25 million in the process in less than five years. 

In the company's most recent fiscal quarter, VA Linux had generated $15 million in sales but had lost $10 million on them. This business, then, was losing almost 70 cents on every dollar it took in. VA Linux's accumulative deficit was $30 million. (amount by which its total expenses had exceeded its income). 

Now, imagine, if VA Linux were a private company owned by your neighbor and he asked you how much you would pay to take his business that was losing almost 70 cents on every dollar it took in. The accumulative deficit was $30 million and in less than five years, the company had sold $44 million worth of software and services but had lost $25 million in the process. 

Will your answer be, "Oh, $12.7 billion sounds about right to me?" or perhaps you would smile politely and gently declined the offer, wondering what on Earth your neighbor had been smoking. 

Because relying exclusively on our own judgement, it's impossible for us to pay $12.7 billion for a company that's making such a big loss. It just doesn't make sense. but when we're in investing in shares, the entire ball game and perspective changes. Because a lot of people (myself included) look at valuation as if it's a popularity contest. The price of a stock seems more important than the value of the business it represents. As long as someone else will pay even more than you did for a stock, why does it matter what the business is worth?

Well, VA Linux is just one of the many examples out there. 

Looking at the historical examples objectively, like the book said, IPO sometimes doesn't stand only for "initial public offering". More accurately, it's a shorthand for It's Probably Overpriced

Warren Buffett once said that IPOs are almost always bad investments. He says there is so much hype involved that IPOs won't be the most-attractive value.

Recently, he made another remark regarding IPO.

“You don’t have to really worry about what’s really going on in IPOs. People win lotteries every day but there's no reason to let that affect [your investing strategy] at all,” Buffett said.

“You have to find what makes sense and follow your own course.”

And like Benjamin Graham's Intelligent Investor, Buffett gave a singular piece of advice for investors deciding where to invest.

“When you buy a stock you get yourself in the mental frame of mind that you're buying a business,” he said.

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