Faceplant? What's so Great About "IPO Pops"?

Let's say a beautiful house is being put up for sale. The agent hired (and paid) to sell the house advertises it everywhere, so all potentially interested buyers know about it. Then the agent calls for bids. The agent explains that there will be only one round of bidding, so bidders need to submit their highest and best offers. Then the agent and the homeowner look at all the bids and pick one, probably the highest. And then the house is sold at that price.

The day after the deal, it is highly unlikely that the buyer would be able to resell the house for the price he or she just paid--because he or she offered the highest bid around. The true "market value" for the house, in other words--the average price paid by most buyers and sellers--might actually be below the price the buyer paid.

The seller of the house, meanwhile, has gotten full market value for the house--just as he or she should.

No one complains that there wasn't a "pop" in the house price.

No one thinks the buyer "got screwed."

No one says the agent should have sold the house at 25% below market value just to give the buyer a "pop."

In fact, if the buyer ever complains that he or she paid too much for the house, everyone will tell the buyer to grow up and look in the mirror if he or she wants to figure out who to blame.

And it's exactly the same for IPOs.

Any "pop" in the stock price on the first day is the difference between the IPO price and the market value.

The market value is not, perhaps, a "conservative value that only a cautious prudent investor would pay," but the market value--the average value that all investors, conservative and aggressive, are paying.

Any investor who chooses to pay market value for an IPO needs to accept that. And if he or she doesn't want to accept that, then he or she just shouldn't place a bid. (This is voluntary stock speculation, after all: We're not talking about selling water and air.)

"But It's Not Like Selling A House... It's Like Selling Apartments!" [No, It Isn't]

There's one more argument that sophisticated "pop" defenders invoke. And that's this:

Selling an IPO is not like selling a house. It's like selling an apartment in a big apartment building with lots of apartments. What you're trying to do with the first sale, the pop defenders say, is generate excitement for the stock, by showing how much money can be made if buyers start speculating on the apartments. If you give away a lot of free money to the first few buyers, this story goes, others will see how much money is being made and then they'll pile in and start buying. And the value of all the apartments will go up!

That argument sounds sophisticated and intelligent, but it's wrong.

Why?

Because the shares in an IPO are sold all at once, not one after the other.

And future sellers of shares in the company--existing shareholders--will not be selling any more shares for months after the deal, at which point the trading price of the stock will be determined by the first day "pop" on the IPO but by what has happened in the interim.

"No!" the IPO pop defenders shout.

"The first-day pop determines everything! Investors who don't get a pop will storm off in disgust, and they'll never come back! The company's stock price will be lower forever, because burned investors will always want to punish the company!"

I hope no one seriously believes this.

The reality is that after a stock settles in the weeks and months after the IPO, what happened on the first day of trading is quickly forgotten. Potential buyers and sellers of the stock react to "news"--to what is happening in the market and industry and at the company--not because of some collective market memory about the IPO price. And, in any event, even in a huge deal like Facebook, the investors who played the IPO are only a tiny fraction of all available investors out there, so even if the investors who didn't get their free-money pop remain disgruntled, plenty of other investors will rush in to fill the gap.

So, if IPOs pops are actually bad, why does everyone think they're so good?

A few reasons:

  • Everyone loves free money, so when a handful of speculators get lucky and make a lot of it (when an IPO is underpriced), they're very loud in celebrating their brilliance and success
  • Pops are exciting and controversial! Pops give the press an excuse to write breathless stories about the IPO, in which they can rave about the "instant overnight millionaires and billionaires" and the "popular madness and delusions of crowds" and other age-old stories that sell newspapers and cause viewers to tune in (and get clicks).
  • Wall Street has brainwashed companies and the media into thinking that pops are good. Why? Because a healthy "pop" makes it easier for Wall Street to keep both kinds of clients happy--not just the issuer (company) client but the investor clients. Wall Street deals with issuer clients only every once in a while, when companies do IPOs or secondary offerings. But Wall Street deals with investor clients every day. So Wall Street loves to dole out favors to those investor clients at the expense of issuer clients. And those favors often come in the form of huge IPO pops.

What a small IPO pop like Facebook's really means is that the underwriter has correctly assessed market value (often hard to do) and then priced the stock just below market value. In other words, they've done a great job for their issuer client and a fine job for their investor clients. Especially on a hot offering, this is extremely hard to do. That's why I said last week that Morgan Stanley had priced Facebook perfectly.

hosed tbi

You'll enjoy this tidbit about how Morgan Stanley decided which clients to give Facebook stock to... (click photo)

Yes, in the week since its IPO, Facebook has traded down sharply. But a lot of that sell-off is due to the NASDAQ screwup and the now-widespread understanding that Facebook is having a weak second quarter (something that was only known by institutions). And a lot of it is also probably due to the fact that many, many players placed orders for Facebook only because they were hoping to get a huge IPO pop.

These speculators--and that's what they are, speculators--did get a nice modest pop. Again, on the first day of trading, unless they were burned by the NASDAQ screwup, they could have sold their stock for 5%-10% more than they bought it for the day before--a spectacular return. And if this was still disappointing to them, well, then, that's because they were greedy.

Meanwhile, Facebook raised $16 billion at a good price, one that--at the time it priced the stock--was just below the market value.

The extra cash that Facebook raised by pricing its stock 10% below market instead of, say, 25%, will create value for the company for decades to come.

If the company executes well, meanwhile, memories of the "broken IPO" will quickly be forgotten.

And anyone who doesn't believe this should just take a look at Amazon.

Back in 1997, when Amazon went public, the stock quickly "broke" the IPO price.

As it was for much of its early history, Amazon was shellacked in the press for this.

15 years later, Amazon is up about 75X from the IPO price.*

And the shellacking has long since been forgotten.

Source: http://www.businessinsider.com/ipo-pops-2012-5#ixzz1wAmZyiBj

Total
0
Shares
Previous Article

The Consumer is Back... Consumer Credit Positive (Even Excluding Student Loans)

Next Article

Going Defensive With Dividend Funds

Related Posts
Subscribe to AdvisorAnalyst.com notifications
Watch. Listen. Read. Raise your average.