First Impressions

Initial public offerings for Internet companies are back in the headlines. Companies such as LinkedIn and Groupon went public in 2011 with multibillion-dollar valuations, and online review site Yelp filed paperwork for its own IPO late last year. This year, Facebook has filed for an offering that could value the social media colossus at between $75 billion and $100 billion.

If this sounds all too familiar, it might be. Research firm MyPrivateBanking compared the latest wave of Internet IPOs to the dot-com bubble of 1998-2000 and concluded that investors should be skeptical of the hot offerings. "Looking at the balance sheets accompanying, in particular, the recent IPOs of social media ventures and Chinese Internet companies, we see a lot of similarities that should worry investors," warns Steffen Binder, research director of MyPrivateBanking. Those similarities include "skyrocketing" valuations and the presence of some of the same underwriters who sold the likes of Webvan, Pets.com and Lastminute.com to investors.

Such similarities suggest that planners should be cautious about IPOs now. But, of course, there are opportunities that tempt many investors. "It's no surprise that IPOs are more volatile than seasoned stocks, but our index shows that their outperformance can be greater than their underperformance, creating alpha for investors," says Kathleen Shelton Smith, a principal at Renaissance Capital, an IPO investment advisory firm in Greenwich, Conn.

DIFFERENT STROKES

Despite some similarities, there are also differences between turn-of-the-century IPOs and those appearing now. "There's a little bit of a repeat but this market is not quite as frothy as the one in the late 1990s," says Mark Luschini, chief investment strategist at Janney Montgomery Scott in Philadelphia. "Outside of social media, there's not much to suggest a fever pitch about new offerings."

In the U.S., LinkedIn's $353 million IPO last May valued the company at $4.3 billion, the largest valuation for a U.S. Internet company since Google went public in 2004, only to be followed by daily deal leader Groupon's $700 million offering in November, which provided a $12.6 billion valuation.

But such Internet-related IPOs were far down the list on last year's leaderboard, as reported by Renaissance Capital. HCA Holdings, a U.S. hospital chain, raised the most money - nearly $3.8 billion - and energy pipeline company Kinder Morgan raised almost $2.9 billion. Even those offerings trailed several foreign IPOs, such as the $10 billion raised by Glencore International, a Swiss-based commodities trading firm. So investors leery of more dot-com busts have plenty of other types of IPOs from which to choose, in many market sectors.

SHORT SWINGS

Not only is the contemporary IPO market diverse, it is also cyclical - with short cycles. Issuance often ebbs and flows with the strength of the stock market.

For example, the first five months of 2011 were generally strong for stocks, so IPOs flowed out to investors. Of the 15 largest IPOs of 2011, as reported by Renaissance Capital in mid-November, 13 went public from January through May. Then, in the third quarter of last year, stocks tanked as the S&P 500 fell nearly 14% and the MSCI EAFE index of foreign stocks plunged 19%. There was a "steep decline" in global IPO activity, Renaissance Capital reported, as "deal flow slowed to a trickle by mid-August." Eighteen U.S. IPOs raised $3.5 billion, down 33% from the third quarter of 2010, while the global total for the quarter was $23 billion, down 49%.

A weak third quarter was followed by October, when stocks bounced back and "the IPO floodgates ... opened," according to Renaissance Capital. Besides Groupon, November IPOs included consumer-review website Angie's List, which raised $114 million, and retailer Mattress Firm, which raised almost $106 million.

Renaissance Capital's Smith contends that an up-and-down pattern may provide IPO investors with an opportunity to obtain superior returns, especially if they buy after periods of low issuance. She cites the performance of the FTSE Renaissance IPO Index, a "rolling two-year population of IPOs purchased at the end of the first day of trading."

As noted, IPO issuance dries up when stocks tank. In late 2002, after a bear market lasting more than two years, there were hardly any U.S. IPOs. Going forward, IPOs picked up and so did the IPO index. That index peaked in late 2007, according to Smith, after gaining more than the S&P 500 or the Russell 3000.

A similar pattern emerged recently: IPOs were virtually nonexistent in late 2008 and early 2009, then picked up gradually in the next three years. Although the IPO index fell by more than 50% in 2008, it recovered with gains of about 55% and 20% the next two years.

As Smith explains, "When IPO activity recovers following a severe decline, IPOs tend to outperform benchmark indexes. This is because only the strongest, most attractively valued IPOs are able to get done in this environment. As a rule, higher IPO activity results in weaker returns, which was the case in 2000."

RISKS AND REWARDS

Although returns may be weak from some IPOs, there also may be considerable upside. Some observers have characterized IPOs as "unseasoned equities," somewhere on the spectrum between venture capital and long-traded public companies. Offerings that go public aren't as risky as venture capital because the firms have more of a track record, but IPOs are riskier than companies that have been publicly traded for years.

"The characterization of IPOs as 'unseasoned equities' is correct," Smith says. "They are a specialized segment of equities - IPOs are the most inefficient category of public equities. They fit further out on the efficient frontier where expected returns should be higher to compensate for the risks."

Some money managers do consider IPOs for their portfolios. "We view some new stocks to see if we want to put them in our funds," says Tim Cunningham, a managing director and associate portfolio manager at Thornburg Investment Management in Santa Fe, N.M. "We sometimes buy on the IPO. We bought Google, for example," he says.

"We're still buying IPO stocks if they're priced reasonably," Cunningham says. "We bought a fair amount of Fusion-io, to name one company." Fusion-io, which went public in June 2011, is a fast-growing data storage company with promising new technology, according to Cunningham. "It's a real company with real customers, such as Apple and Facebook," he adds. Fusion-io, which went public in June at $19 a share, was trading around $23 in mid-February.

Despite reports of such success in a weak market, some planners avoid IPOs. "We do not put clients in IPOs," says Mark Balasa of Balasa Dinverno Foltz, a wealth management firm in Itasca, Ill. "It's too hard to get access even if we wanted to." Balasa adds that clients aren't demanding to participate. "It's nothing like back in 1999-2000."

Bill Brennan, founder of Capital Management Group in Washington, D.C., agrees. "IPOs just do not fit with our style or our clients' goals," he says. "We have never been asked to track down and buy shares." Brennan's clients prefer principal preservation with a reasonable return.

SAFETY IN NUMBERS

For clients who do want an allocation to new offerings, Smith suggests spreading the risks. "Investors should own IPOs in a diversified portfolio," she says. Her firm offers a Global IPO Plus Aftermarket mutual fund, which was launched in 1997. Another mutual fund, Direxion Long/Short Global IPO, introduced in 2010 - too new to have much of a trading record - can sell short new offerings believed to be overpriced as well as invest in promising issues.

Subadvisor to the Direxion fund is IPOX Capital Management, which produces IPO Indexes. The IPOX-100 U.S. Index is tracked by First Trust U.S. IPO Index Fund, an ETF launched in 2006. This ETF, classified as a large growth fund by Morningstar, had a steep loss of 44% in 2008, followed by sizable gains of 45% and 18% in 2009 and 2010. The Global IPO Plus mutual fund, which is in the mid-cap growth category, had a somewhat smaller loss of 33% in 2008 and smaller gains of 16% and 13% in the following two years. Smith says that Renaissance Capital will be offering a series of ETFs based upon her firm's IPO Indexes.

THE INSIDE STORY

These three funds all have less than $15 million in assets, indicating that most IPO investors prefer individual issues rather than a basket of newcomers. Planners who are considering this approach should tread carefully.

"IPOs are not all bad, but they're not all viable," says Jim Krapfel, an equity analyst and IPO strategist at Morningstar. "You must put in the time to look at the firm. They should evaluate the business prospects and look at valuation."

One factor to consider arose in the Groupon IPO. The firm's founders and early investors reportedly cashed in for hundreds of millions of dollars before the IPO, which created skeptical buzz. "It's common for founders and early investors to sell a portion of their stakes," Cunningham says. "Often, founders have the vast majority of their personal wealth tied up and want to diversify some of the risk, typically after several years of illiquidity."

Nevertheless, Cunningham adds, "Insider ownership is an important metric. High insider ownership tends to mean that they believe in the future prospects of the company."

To be sure, not every planner will want to delve deeply into individual IPOs. A simpler approach to IPOs is simply to wait and see. "Waiting is prudent," Krapfel says. "You'll want to see an economic moat to keep out competitors, and you'd like to see profits."

Donald Jay Korn is a contributing writer at Financial Planning. His latest novel, In for a Pounding, is available on Kindle and Nook.

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