Alibaba and an explanation of IPOs

Sam Swift

Oct 2, 2014

By: Sam Swift, CFA, CFP®

It seems that a couple times per year, a new company gets a lot of media attention for going public. You likely heard about the recent IPO for Alibaba, a Chinese e-commerce company, so it’s worth discussing what all the hoopla is about.

An IPO (Initial Public Offering) is the first sale of stock by a company to the public. A company may choose to go public for any number of reasons, but ostensibly the main purpose is to gain access to a larger pool of capital for further growth and investment. IPO’s began generating more and more headlines as the dotcom bubble of the late 90’s heated up. Whereas prior to that time a company would only qualify for an IPO with sound financials, the tech boom saw an irrational demand for companies to go public—including many that had yet to even generate revenue!

IPO activity cooled off significantly following the bursting of the tech bubble, but the allure of “striking it rich” has certainly lingered with the financial media. Let’s walk through the case of VA Linux1—a firm that set the then record for first-day price appreciation—to show how this media narrative may not be what it seems. After its first day performance, the Wall Street Journal ran a headline “VA Linux Registers a 698% Price Pop” that offered the following analysis: “Offered at $30 a share, VA Linux exploded to end the day at a 4 p.m. price of $239.25”. So what’s wrong with that, you may be asking. Well, if you were lucky enough to get in at the IPO offering price of $30, then nothing is wrong and you were likely extremely happy with the first day results. But that’s the rub—it’s extremely difficult to get in at the IPO price.

When a company is preparing to go public, they need to use an investment bank to help file the proper forms and set the initial price. The investment bank then gets to place the shares with whomever it wants to, basically. If you happen to have an account with the underwriting investment bank, you could theoretically be allocated some shares. As a relatively small investor, however, here’s how it typically works: you ask the bank for IPO shares and then the bank proceeds to pocket veto your request and move on to larger, more profitable clients.

Thus, when we look at what happens to the common investor—that is, the investor who has to buy in through a stock exchange once the IPO shares begin to be publicly traded—we get a muddier picture. For VA Linux, trading opened at $299 (up from the $30 IPO price), went up to $320 and finally closed at $239.25. Thus, if you bought at the opening price in an attempt to participate in this hot IPO, you ended up looking at a 20% loss on the first day of trading. Even in the case where you get in at the IPO price, the headline grabbing first-day returns turn out to be largely irrelevant since you’re typically restricted from trading your shares for a set amount of time (assuming you want to participate in future IPO’s). Here’s the chart for VA Linux following the opening day2:

VA Linux following the opening day

A six month restriction would have seen your shares plummet over 80% in value before you could do anything.

It should come as no surprise that financial headlines aren’t telling the whole truth. In fact, there’s a great website (well at least great for data nerds—it’s probably not winning any design awards) where previous IPO’s have been tracked for some time. According to that data, here’s what we see for the three years following an IPO:

IPO

Look at the bottom line. There were 7700 total IPO’s over the 1980-2012 period that returned a total of 22.3% on average for the three years following their debut—a bit over 7% per year. Not bad in a vacuum, but we when we compare it to the market as a whole and compare them to stocks with similar characteristics (style-adjusted), we see that they underperform.

None of this is to say I have any idea how Alibaba will perform in the future, but just to remind you that even a highly publicized IPO is still just an individual stock in the end. The exclusivity and chance to “strike it rich” play perfectly for media headlines, which is as good an indication as any that as long-term investors we don’t need to bother ourselves with them.

1 I was alerted to this example by a Weston Wellington article from years ago that can be found here. The numbers you’ll see are taken from that article.

2 http://www.sfgate.com/business/article/VA-Linux-Easy-Come-Easy-Go-Stock-s-dramatic-2962977.php

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