Should You Invest in an IPO?
By Joshua Kennon. Investing for Beginners Expert
Thanks to his straight-forward approach and ability to simplify complex topics, Joshua Kennon's series of lessons on financial statement analysis have been used by managers, investors, colleges and universities throughout the world. "If an investment idea takes more than a few sentences, or cannot be explained to a reasonably intelligent fourth grader, you've moved into speculation," Joshua insists. "Whether you're dealing with a public company such as McDonald's, or a private company such as Chanel, these are the types of firms that are easy to understand. You know where the sales originate, what the costs are, and how profits are generated. These are the types of enterprises that aren't going to cause you to wake up in the middle of the night, breaking into a cold sweat because of the sub-prime crisis or esoteric securities trading in illiquid markets. That's a huge advantage to growing your wealth. Focus on what you know, pay a fair price, and invest for the long-term.
Investors are people. They like novelty; get excited by something new, especially if it holds the promise of making them a whole lot richer and provides bragging rights at their next cocktail party. Maybe that’s why amateur and professionals alike tend to lose their minds in bull markets. particularly when a hot initial public offering, or IPO, is offered to them by their broker.
On one hand, had you bought into the initial public offering of Wal-Mart. Home Depot. Walt Disney, Dell, Microsoft, Coca-Cola, Target, or Starbucks, you may have had some volatile price fluctuations along the way, but there is no question that you have made enough money to substantially change the quality of your life.
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A single share of Coca-Cola purchased for $40 at the IPO in 1919, for example, crashed to $19 the following year. Yet, today, that one share, with dividends reinvested. is worth over $5 million. Likewise, $10,000 invested in Wal-Mart is now worth $10 million plus. Clearly, a well chosen IPO investment can be a life changing experience if you simply make the right choice and stick the stock certificates in your safety deposit box for thirty years. On the other hand are companies such as WebVan, the bankrupt web grocer that left investors with total losses, licking their wounds and draining their portfolio of precious capital that could have compounded into huge nest eggs if given enough time.
Benjamin Graham. the father of value investing and much of modern security analysis, recommended in his treatise The Intelligent Investor. investors steer clear of all initial public offerings. The reason? During an IPO, the previous owners are attempting to raise capital for expanding the business, cash out their interest for estate planning, or any other myriad of reasons that all result in one thing: a premium price that offers little chance for buying your stake at a discount.
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Often, he argued, some hiccup in the business will cause the stock price to collapse within a few years, giving the value minded investor an opportunity to load up on the company he or she admires. As even our Coca-Cola example proved, this often turns out to be case.
The problem comes from the fact that if you find a truly outstanding business – one that you have conviction will continue to compound for decades at rates many times that of the general market, even a high price can be a bargain. Indeed, looking back a decade ago, Dell Computer was an absolute steal at a price to earnings ratio of 50%! It was, in fact, the ultimate value stock. Given the difficulty of sorting out the chaff from the wheat, you are probably going to do better by sticking to your guns. In theory, Graham’s position is one of conservative, disciplined safety. It ensures you won’t get burned and the average investor will likely be well served in the long-run by adhering to that principle. If you insist upon risking your capital. however, ask yourself a few key questions:
- If this business does not grow at a high enough rate to justify its price, what is the likely cause? What are the probabilities of these failures occurring?
- What are the competitive moats that protect the business? Patents? Trademarks? Key Executives?
- Would you be comfortable owning this business if the stock market were to close for the next thirty years? In other words, is this business model and the company's financial foundation sustainable or is obsolescence as a result of technological advancement or lack of sufficient capital a possibility?
- If the stock falls by fifty percent due to short term problems in the business, will I be able to continue holding without any emotional response if I determine that the long-term potential of the business still remains promising?