William J. Bernstein
The $100 Billion Oxymoron
I generally don't comment on initial public offerings; there are some neighborhoods in town I consider it wise to avoid, and when it comes to investments, this is certainly one of them. The classic 1991 study on the subject by Jay Ritter in Journal of Finance, for example, showed that initial public offerings (IPOs) produced a first-day pop of 16%, then underperformed the market by an average of 28% over the next three years.
From the perspective of the first-day return, the average IPO is "underpriced," designed as a bon-bon to preferred brokerage customers. The "success" of the IPO is thus defined by the profit provided to these initial purchasers, who are favored by the wirehouses in the same way that casinos favor the highest rollers. That the issuing company and the later purchasers do not come out so well doesn't seem to enter into this rather perverse calculus of success.
But don't feel too sorry for issuing corporations, they are past-masters at cranking out expensive shares when the markets are frothy (not only as initial offerings, but also as seasoned ones) and issuing debt when markets are cheap. In fact, if you've ever wondered just who is taking the opposite side of the average mutual fund investor on the wrong end of the dollar-weighted/time-weighted gap, the answer seems to be corporate CFOs.
Several things struck me about the tsunami of media attention over the "failed" Facebook IPO. The first was the discovery by participants that instead of being able to quickly flip their purchase to a second-day patsy, they were the patsies (at least after one week).
But even more remarkable was the inappropriate application of the term "investor" to Facebook's unhappy purchasers. Whenever faced with a novel financial phenomenon, it's always useful to ask "What would Benjamin Graham say?" Most pertinent is his classic definition of "investing" from Security Analysis:
An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.
Back in the 1930s, when Ben Graham first penned the above words, it was easy to find securities meeting those stringent requirements. Nowadays, it's a bit harder, so perhaps adding "a reasonable probability of" to "safety of principal and an adequate return" would not be uncalled for. It goes without saying that "investing" requires some computation: with a triple-digit P/E, Facebook will have to grow its per-share earnings by at least a factor of eight to justify its price (taking into account that the calculated per-share earnings probably does not include planned future issuance of shares).
How many Facebook purchasers do you think have exerted the considerable effort of estimating Facebook's future advertising revenues? Using the word "investor" to describe these folks is akin to calling Tony Soprano a Catholic. Joe Nocera got closest to the truth when he opined, "Virtually everyone who bought Facebook on that first day was making a one-day, get-rich-quick calculation. It didn't work out. Too bad." (To which I would add this silver lining: That the speculating public will still blindly overpay for growth and glamour strongly suggests that the value premium is yet alive and well.)
However acute the observations of Graham and Nocera may be, my go-to for general investment wisdom is a relatively unknown writer named Fred Schwed, who in 1940 wrote his only investment book, Where Are the Customers' Yachts? And indeed, on the subject of "investor" anger over the Facebook debacle, he does not disappoint:
The burnt customer certainly prefers to believe that he has been robbed rather than that he has been a fool on the advice of fools.
"Fool"? Most likely. "Investor"? Definitely not.
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