So they let a hoodie into the stock exchange and everyone got mugged. Well there’s a surprise. Facebook (NASDAQ:FB) has not only damaged its credibility but also the net wealth of hundreds of thousands of investors. The fact that the much hyped float has collapsed by close to 20% from its offer price in just a couple of days has ensured this shambles and its repercussions will remain on the front pages for a long time to come, but what gets less press is the fact that the Facebook listing is just the latest in a long line of IPOs that have been utterly disastrous for investors. In essence the average stock market investor is treated as the fool that the smart money sells to whenever it fancies a good exit and pays the consequences. This trail of consistently dire big IPO underperformance seems more and more like a form of systemic fraud. Can it be avoided? Let’s investigate…
Big IPOs, Bigger Investor losses? A brief look at the larger capitalisation IPOs of the last few years shows a litany of disaster for anyone caught up in them. Many of these companies are household names brought to market by the most glamorous investment banks in the City, but there’s certainly been no glamour for buyers. The latest quotes show that Betfair (LON:BET) has slumped to reside an astonishing –52% below its float price, Ocado (LON:OCDO) –36%, Glencore International (LON:GLEN) –33%, Supergroup (LON:SGP) –41% and African Barrick Gold (LON:ABG) –39%. Hmmm spot the trend anyone?
Earlier this decade Debenhams (LON:DEB) was a classic case study in the way the smart money plays the stock market. In 2003 the fiduciaries of the wealth of millions on the stock market (i.e. fund managers) sold Debenhams to a consortium consisting of company management and private equity (i.e. smart insiders) on the cheap. In 2006 only 3 years later they then bought it back again when those same insiders re-IPO’d the company and more than tripled the value of their equity stake in the process. In the next 11 months after flotation Debenhams proceeded to issue three profit warnings and the stock collapsed 20%. It now languishes 62% below that float price.
How come privately held equity keeps getting away with what in hindsight are such excessively priced initial offers? If every investor knows that a strategy of selling low and buying high from better informed counterparties is a fast route to the poor house, why would our best fund managers consistently fall into this trap?
Forced buyers and suckers to the glamour effect
Part of the answer is that many fund managers often don’t have any choice but to buy big IPOs in order to keep their jobs. Fund managers job security comes down to their ability to match their benchmark (FTSE 350 etc) on a quarterly basis. If they diverge from the benchmark for too long they are likely to be fired. In just the same way as cattle on the prairie herd together for safety in numbers this so called ‘career risk’ turns many big funds into ‘closet tracker funds’. If they don’t participate in a big IPO that may enter the index their tracking error will increase substantially - putting their jobs at risk.
Not only do fund managers have to buy, but the vendors make damn sure that they want to buy too. The huge amount of press and attention given to big IPOs encourages a whole ream of behavioural biases that lead to sub-par decision making. The over-exposure of the story in business press creates an availability bias, one-on-one meetings with high profile executives encourage the halo effect, selectively disseminated documentation leads to over-confidence. The sell side make damn well sure that they play all these tricks to the max, magnifying the already implicit herding behaviour of fund managers. But as regular readers of Stockopedia ought to know well by now glamour just doesn’t pay.
You would have thought that investors would have learned by now that they shouldn’t buy from smart insiders at anything but a sharp discount. Directors deals on the secondary market are one of the best indicators of future business performance - why would IPOs be any different? As has been pointed out time and again the insiders who are selling these companies have access to private information that is under-disclosed to buyers - they wouldn’t be selling their stake unless they were receiving full value. The scandal currently erupting around Facebook is that future cuts to earnings estimates weren’t disclosed to all parties at the IPO. Tout ca change?
Doesn't the growth equity raised increase future returns?
But surely the capital raised will help floated companies outperform in the future? That’s what IPOs are for? While that’s regularly the case for smaller IPOs the research suggests that big IPOs “are not able to sustain in the aftermarket the pre-IPO levels of profitability”. Capital raised in big IPOs seems to be predominantly used to reduce debt levels rather than for investment. While Facebook may be sitting on $18bn of cash right now, any student of Warren Buffett will know that when average management meets large sums of cash good capital allocation doesn’t always result - in fact the temptation is for managers to indulge in ‘empire-building’. Instagram anyone?
How not to be a patsy...
The sum of all is that when big companies float a set of smart well-informed insiders sell to a captive set of easily manipulated forced buyers. These are the perfect conditions for the over-valuation of shares. Mean reversion of the valuation on its own would result in under-performance but this is exacerbated by the regular misallocation of the funds raised.
If you have some of your money tied up in nice FTSE tracker funds or actively managed ‘closet’ trackers that are benchmarked to those indexes you can be very sure that you’ve been extremely exposed to the shocking under-performance of recent big IPOs. But as a private investor you don’t have to play the part of the patsy. You can make the decision not to rely on these fund managers who are making hopelessly bad decisions for you.
You need to start thinking the way insiders and private equity houses do about the stock market. Start seeing Mr Market as a bunch of dumb money prone to wild over and under enthusiasm. Play him for all he’s worth - when he quotes you something silly take advantage of it. Switch off the TV and certainly don’t listen to those with vested interests. Get some good research tools and make smarter decisions. It’s never been easier to research the market and find the kinds of smaller cap value stocks and turnaround situations that can in aggregate beat the market return. You don’t need someone making bad decisions for you… make better ones for yourself. And the next time you see a sharp suit at the stock exchange… think twice - he normally wears a hoodie.