I was interviewed by the University of Maryland about the risks and rewards of investing in IPOs.
IN A BIG YEAR FOR STOCK DEBUTS, INVESTORS BEWARE
Apr 03, 2019
SMITH BRAIN TRUST – Shares of Lyft (NASDAQ:LYFT) were still sagging days after the ride-hailing service had its initial public offering on the New York Stock Exchange. And that had Maryland Smith’s David Kass offering some advice.
In what’s poised to be a big year for big-name IPOs, Kass lists five reasons to ease up on the gas pedal and proceed with caution.
Beware the hype
Lyft began trading on the Nasdaq on Friday, March 29. It debuted at $72, climbed to $88, and closed the day at $79. Not bad, but on Monday, its second day of trading, Lyft’s stock was down 10 percent from its debut, trading at $70, and then continued to slump.
It seemed an inauspicious start, but it’s what often happens, Kass says. Lyft’s IPO was oversubscribed, or sold out, as many debuts are, meaning only the biggest investors – typically pension funds and other institutional investors – could buy in at the price set by the underwriting brokerage firm. The general public, meanwhile, would be forced to wait until shares go onto the market. “That’s when the shares get pushed up from $72 to $88 a share,” says Kass.
“If the IPO is going to be very popular, it’s very unlikely that the average investors can get in at the IPO price, very unlikely. The average investor is going to have to pay a premium on the first day, and it could be substantial.”
That’s because quite often, investors who are able to get in at the IPO price will sell their shares immediately at an instant profit. “For them – for the initial purchasers of an IPO that’s oversubscribed – it’s almost a guaranteed profit. There is almost zero risk for them.”
Hope for FB, but remember SNAP
“I describe the IPO market as high-risk with potential high-return,” says Kass. “It’s very speculative. Some IPOs work out very well, but many do not.”
There was a lot of excitement and speculation in 2012 ahead of Facebook’s (NASDAQ:FB) IPO. Facebook was such a popular product for such a long time, and finally, the public was going to get an opportunity to invest in it.
Its shares initially traded for $38. A slew of typical small, Facebook-loving investors grabbed up shares as soon as they could, many of them paying the high of the day: $42 per share. “Three months later, August of 2012, you could have picked up shares of Facebook for $17.”
These days, Facebook is up by a factor of 10, trading recently around $170. It’s been as high as $218, Kass notes. “It’s an example of a company that is big and visible – and profitable – but there was still enormous risk,” Kass says.
Look at Snap (NYSE:SNAP), parent of Snapchat. Its shares debuted at $17 in 2017, and swiftly surged above $30, before coming back to earth. Its shares today trade around $11. Investors who held on from Snap’s earliest days would have been in for a wild ride, surging as high as $32, plunging as low as $4.82.
“For those who bought in at the IPO or above the IPO price, they were taking a pretty big risk,” Kass says. “Two years later, and it’s down by a third from the IPO price.”
Know what you don’t know
If the company debuting its shares hasn’t yet turned a profit, as in the case of Lyft and its larger rival Uber (UBER) (also planning an IPO this year), it’s hard to estimate future earnings. It’s a reason to remain cautious, Kass says.
“No one knows just when Lyft or Uber will turn a profit, if they will ever turn a profit. And you don’t want to invest in a company unless you expect it to be profitable, and in some reasonable timeframe,” says Kass. “If a company doesn’t turn a profit within 5 years or soon thereafter, it is likely to disappear.”
There’s simply a limit as to how long a company can remain unprofitable and stay in business.
“Take Warren Buffett’s approach as an example,” says Kass, who has followed Buffett’s investments and philosophy for more than 35 years. “When he looks at a stock, he looks out five years and looks at what its likely profits will be in five years, then discounts those profits back to the present at some reasonable discount rate, and calculates what a fair price would likely be today.”
It’s not easy, Kass admits. “It’s very hard to predict what the likely earnings and cash flows will be five years from now from a company that isn’t profitable today,” he says.
Consider your rights
Tech IPOs increasingly favor a dual class share structure. The first class goes to insiders – company execs and founders – and bestows a majority of the voting power on that small minority of shareholders. It concentrates power in the existing management and leaves the shareholding public with limited voting power and minimizes the impact of traditional market forces. “It takes away the shareholders’ ability to put the CEO’s feet to the fire,” Kass says.
Most publicly traded companies have just one type of stock and it comes with voting rights, one vote per share. If a company is underperforming or inefficient or making bad decisions, Kass says, an activist or other outsider should be able to come in and offer to right the ship, calling for changes or proposing a takeover. And the shareholders, traditionally, would have a chance to vote on the reforms or merger.
Not so under the new dual class share model followed by Lyft, Facebook, Snap and others, Kass says. “The insiders, in these cases, control a majority of the shares with votes. And therefore an activist investor’s move or a hostile takeover wouldn’t work.”
It’s a matter of financial and market discipline. “Minus that discipline,” he says, “and the insiders don’t have as much of an incentive to maximize profits, to maximize shareholder value, to maximize share price. They can sit on their laurels, and there is no external market discipline on them.”
It short-changes shareholders. “It violates what was intended by the democracy that was set up by corporations, the idea that one share means one vote and every share is treated equally.”
Channel Warren Buffett
Kass recalls being at the Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) annual shareholders meeting with a group of Maryland Smith students just weeks before the Facebook IPO, and watching Buffett talk about his views on hot market debuts. A shareholder had asked – without naming Facebook – whether the firm would invest in IPOs. “Everyone there, all 40,000 shareholders, knew that he was really asking about Facebook,” Kass says. “Facebook was the most famous IPO in years.”
Buffett replied, saying it had been decades since he had bought an IPO.
“He said something interesting that has stuck with me. He said, ‘Companies themselves choose when they will go public. So if you buy an IPO, you are paying for the company’s stock at what the company thinks it the optimal time to sell.’ And he added, that with all the hype that surrounds the stock’s public debut, it’s very unlikely that a company’s stock on its IPO day would be more attractive in price than all of the other stocks in the market on that particular day.”
Consider, too, Kass says, that traditionally the busiest IPO seasons coincide with stock market highs.
It doesn’t make for the best timing, he says, for a value investor.
Disclosure – (for Berkshire Hathaway): I currently own shares in its class B stock NYSE: BRK.B.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.