More than a decade removed from the dot-com era, investors are
once again reverting to bad habits. They're chasing seemingly sexy
hot IPOs (initial public offerings) as they rise ever-higher and
are often the last ones left holding the bag when reality
eventually sets in and these stocks steadily fall.
We've already seen this scenario play out earlier this year -- and
it's happening again. Recall that at the end of 2011, investors
were buzzing about the year's hottest IPOs:
As a reality check, I took a closer look at these business models
in February of this year
and concluded that only LinkedIn had the makings of a tangible
. Both Zynga and Groupon looked sharply
at the time, as investors were clearly buying into a future that
may never materialize. Here's how these stocks have done since
After the post-IPO buzz died down and additional quarterly reports
rolled in, Groupon and Zynga could no longer sustain their
valuations, which exceeded $10 billion at their peaks. And the
selling may not be done. Groupon resorts to
, and it's unclear that the company's projected $0.75 in 2013
earnings per share (
out of this business or not. Zynga is doing its best to use its
post-IPO financial strength to buy its way into long-term
relevance, but as the recent sell-off in traditional games makers
Electronic Arts (NYSE:
tells us, you're only as good as your last hot gaming title. It's a
bit hard for me to see upside for LinkedIn from here, but at least
this is a real business model.
Investors only want to own these stocks simply because they think
other investors will want to own these stocks even more. So their
appeal lies in an intangible and ephemeral notion of perceived
value that others hold.
And right now, a fresh crop of recent IPOs is again soaring ever
higher, and the majority will eventually have to face up to the
reality of quarterly reports, and not simply a game of hot potato.
To establish a baseline of what a new IPO is worth, you need to
look back at the IPO pricing process. Let me give an example.
As investment bankers were preparing the final paperwork for
, they figured they could line up demand for
if they were priced in the low to mid-teens. That pricing is
determined by comparing a newly-public company to the valuations
that are accorded to rivals, or to companies that have recently
been acquired in private
transactions. The company's bankers even prepared for the
possibility that the deal would be priced as low as $8, in case
demand for shares was weak.
Well, a string of IPOs had performed very well in recent months,
firms and other powerful investors that tend to buy into these
deals needed to hop on the bandwagon in search of another hot
stock, so they angled for a piece of the Splunk IPO. That was a
wise move: Shares were priced at $16 last week and opened up in the
low $30s -- a magical instant 100% gain.
Make no mistake, the current share price does not reflect Splunk's
business prospects, but instead the relative scarcity of its
shares. Sure, this stock could go higher, but since the bankers
thought it was worth $15 to $16 by comparing it to the value of
peers, Splunk would have to deliver stunning quarterly results to
justify the new valuation.
This same logic applies to a group of other hot IPOs. For example,
, which makes organic grocery items, was worth less than $20 a
share just a month ago when its bankers were trying to come up with
a suitable stock price for the IPO. A month later, it has nearly
doubled from that perceived valuation. This company has been around
for more than a decade, posting moderate annual growth. Why is it
now suddenly seen as a hot growth stock?
[block:block=16]Risks to Consider:
As we saw with Groupon and Zynga, these stocks can levitate for
several quarters before reality settles in. And in the event of a
, their small trading floats bring additional risk if you choose to
Action to Take -->
These hot IPOs face a looming major hurdle: 25 business days after
the IPO, the analysts that have committed to following these stocks
will issue fresh research reports. These analysts tend to simply
re-hash the valuation analysis that their investment banking
colleagues produced for the IPO pitch books. As a result, price
targets for these IPOs are often only moderately higher than the
price. For companies like Annie's, Splunk and others, the analysts'
initial target prices may end up being markedly lower than the
current share price.
As a longer-term challenge to these hot IPOs, insiders will
eventually be able to sell their hefty pre-IPO stakes, which could
drive the shares down. That's why it's always wise to exit a stock
well before the 180-day lock-up expiration expires. It was a tough
lesson learned by investors in
, which I use to own in my
$100,000 Real-Money Portfolio
. The company has largely delivered on the financial goals it has
established for investors, but wave after wave of insider selling
has put considerable pressure on shares.
The point is, when it comes to the latest hyped IPOs, most
investors are better off looking for gains elsewhere.
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-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.