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BEING STREET SMART 

by Sy Harding

Please Let Me In On That IPO! (July, 2001)

Every decade or so a new generation of investors discovers the stock market, and think they've discovered a perpetual motion money-making machine that never breaks down. The market lets new investors' enthusiasm run until the greed and complacency reaches an extreme, until all their money is in, and then teaches valuable lessons about how the markets really work.

The result is that over the last 100 years there have been 29 bear markets, or one on average of every 3 1/2 years. Their average decline has been 30% for the less volatile Dow and S&P 500, considerably more for the more speculative and volatile Nasdaq type stocks.

In the nine worst bear markets of the last 100 years the Dow lost an average of 49%, and the more speculative stocks considerably more. Typically each bear market gives back the last couple of years of gains, but sometimes much more. The 1973-74 bear market gave back 12 years of gains. Usually it's whatever it takes to get the S&P 500 back to selling at fair value of 10 to 14 times its earnings.

When the market teaches its lessons some pay attention and will be experienced and more successful investors for the next cycle. Others will spend their entire lives paying no attention to the lessons, or what happens in every cycle. They are taken in on both the upside and the downside of each cycle, by how Wall Street tells them to react, and wind up blaming their poor performance each time on bad luck.

One of the most consistent lessons the market teaches is that as stocks become more and more overvalued in bull markets, more and more owners of privately held companies become enticed to sell some of their company to the public, and more and more people who have no cash to start a business find it easier to raise money from public investors if they can tell a convincing enough story. So as bull markets mature the number of initial public offerings (IPOs) soar.

Investment banks, experienced with promoting interest in stocks, have unique opportunities with IPOs. As with any new product that comes to market (Cabbage Patch dolls, baseball cards, the Mazda Miata, Plymouth PT Cruisers), if supply is kept scarce much higher prices can be demanded.

With IPOs the manipulation begins with investment banks forming pools of brokerage firms that will participate in selling the offering. Each firm reports back the initial interest, what demand there should be for the stock among its major customers, primarily the mutual funds that are its customers. The investment bank then readjusts the total number of shares that will be offered based on that initial interest, making sure to keep supply scarce. That assures that public investors will have to scramble for the shares in the open market after the initial shares have been sold to mutual funds and favored large customers. It also assures that those mutual funds and large customers can make a large and quick profit by immediately selling (flipping) the shares to the public demand a few days after acquiring them. That makes the funds willing to support and buy the investment bank's next IPO, whether or not it's a good company. In fact the agreement between brokers and funds is usually that the fund will buy every IPO that is offered to them, good or bad, or risk not being allocated any shares in the good ones. So with each supporting the other's interest, the investment banks and mutual funds guarantee profits for themselves in every IPO, and leave the public holding the bag and the risk once the stocks are flipped to the public in the feeding frenzy that follows.  

In the excitement in the final two years of the last bull market IPOs again became hot items. It was not unusual for a company and its investment bankers to initially decide their stock was worth maybe $3 a share, but in the high demand for IPOs that they could probably sell 5 million shares at $10, only to discover they were able to drum up even more pre-issue interest than they expected. So they would raise the offering to maybe 8 million shares and at an even higher price of perhaps $15. In the trading frenzy in the after-market as mutual funds began flipping the shares to take their profits and make more shares available for public investors, many IPOs saw their shares triple, quadruple, and more, shares offered at $15 often selling at more than 100 within a few weeks. Once the frenzy ran its course and investors began actually 'seeing' the losses the companies were generating, the crashes down were often as spectacular as the initial spike up. Losses from the peaks were often more than 90%.

ANOTHER LESSON LEARNED?

Some revealing data is now in on the IPO market of the last bull market. Of course it was known all along that mutual funds were making large gains, adding substantially to their performance, by flipping IPOs. And certainly investment banks were not thought to be losing money in handling the deals. And now we have some data.

Barron's, in conjunction with Dealogic, compiled the fees earned from IPOs by major investment banks compared to the losses compiled by investors in the IPOs. The study covers only IPOs that were brought to market between mid-1999 and mid-2000, and makes its measurements from their first publicly traded price to the price by mid-2001. Some examples:

Morgan Stanley earned $517 million in fees during the period. Its IPOs suffered losses for investors in them averaging almost 55%. Goldman Sachs earned $478 million in fee revenue, while the IPOs it brought out are now down 54% from the the first price at which they were available in the open market to investors. Credit Suisse First Boston earned $425 million in fees while their IPOs have declined an average of 43%. The biggest declines were in IPOs brought out by Robertson Stephens, which lost an average of 66%. Keep in mind that those declines are from the first price they traded at in the open market on their first day of trading. By far the majority of investors bought those IPOs at far higher prices than those first trades.

The thought of how much $1,000 invested in Microsoft's or WalMart's initial public offering would be worth today, helped fuel the demand. Obviously those hoping they were getting that next needle in the haystack, did not.

ANOTHER LESSON - ON INVESTING OR SPECULATING?

In a recent commentary we compiled a comparison of the performance of the Nasdaq to the stodgy old Dow over recent years. It seems to have another lesson the market has decided to teach again. 

The Nasdaq provided a lot of flash and excitement on the way up but:

The stock market is the best investing vehicle of all, better than real estate, better than bonds, better than collectables. But far too many public investors either lose money over the long-term or fail to beat the return they would have from simply leaving their money in the bank. As we said in our 1999 book Riding the Bear - How to Prosper in the Coming Bear Market, whether or not they make money does not depend on how much they make on the upside of the cycle, but how much they keep, by taking those profits in a timely manner, and just as important, perhaps more so, how they handle the downside of the cycle.

Typically, those who kept on buying near the tops were handed their heads on a platter.

In the subsequent bear market, those who were too anxious to get back in and make up their losses, believing Wall Street's story that each low on the way down marked the end of the bear market, piled up still more losses.

Those who sold on the way up, following the example of insiders and experienced investors, and ignoring the hype of Wall Street and the financial media, kept their gains. Those who recognized that the rallies on the way down were only rallies within an ongoing bear market, entered and took profits from them quickly, (in addition to being willing to sell short) also made money on the way down.

The lessons are always there.

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