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Twitter’s IPO Likely Not a Good Bet for Retail Investors

Yahoo! Finance
Hot Stock Minute

By Aaron Pressman

An iconic company in a fast-growing market is going public and the general public is invited, even encouraged, to invest.

That’s the storyline for Twitter’s initial public stock offering this week — but it’s hardly original. And, historically, it generally doesn’t work out so well for individual investors who hope to get in on an early pop.

Without a doubt, the market for technology IPOs is hot. The average 30-day gain for this year’s crop of tech IPOs is 43%, according to Dealogic. This is the highest since deals rose an average of 71% in 2000 — just before the Internet bubble popped. Benefitfocus (BNFT), which sells an Internet-based insurance benefits service, doubled on its first day of trading in September and mobile-ad firm Rocket Fuel (FUEL) almost did the same in its October debut.

But retail investors often overlook just how hard it is for individuals to get in on the hot IPO deals at the original offering price. Wall Street firms allocate most IPO shares to their biggest and most profitable customers, the funds that pay the most in commissions for trading and other services; almost all shares in an IPO go to big hedge, pension and mutual funds. The funds often cash out quickly as soon the shares start trading. The rest of us have to buy after the stock starts trading, when much or all of the gains are already priced in.

In the Benefitfocus IPO, for example, big investors got to buy shares at $26.50 before trading started. After the shares hit the market, mom and pop investors had to pay as much as $55.87. The shares have since slumped under $48, leaving mom and pop still underwater.

The average return

The average first day return on this year’s tech IPOs was 39%, gaining only four percentage points more over the following month, according to Dealogic. Last year, first day gains averaged 26%, with just six percentage points added over the next month.

But what if brokers start calling around to pitch IPO shares to their regular clients? Is this a boon for the retail investor? Actually, if underwriters of a supposedly hot IPO suddenly start flogging shares to the general public ahead of the deal, that’s an even bigger warning sign. Investors should follow the old adage attributed to Groucho Marx: I don't care to belong to any club that will have me as a member.
Facebook (FB), one of the biggest IPOs of all-time, raised $16 billion in its debut last May. To raise that much money, underwriters had to go far beyond the big investors and let ordinary investors get in, too. When big investor interest is tapped out, that’s often a signal the smart money has doubts about the company or that underwriters are selling more shares than the market can absorb.

In Facebook’s case it was a sign of both problems. Some big investors had been tipped to analysts reducing their projections for Facebook’s growth rate. And there was little demand to buy shares once they started trading. Priced at $38, Facebook started slumping on the second day of trading and didn’t hit bottom until it dropped below $19 in November. Only investors who hung on until July saw the share price rise back above the IPO level.

And Facebook was hardly an exception. The $11 billion IPO of AT&T Wireless in 2000 was pitched to millions of the company’s employees and customers. The shares quickly tanked. In another deal offering an iconic brand, Visa (V) went public in 2008, just ahead of the credit crisis market collapse. And heavily hyped social media stocks Groupon (GRPN) and Zynga (ZNGA) crashed after going public in 2011; they haven't yet hit their IPO prices again.

Sitting out the initial hype can provide better opportunities. Investors who bought Facebook at $20 last year have made a killing. Even though they never made it back to their offering prices, Groupon has doubled this year and Zynga is up 56%.

Increasing the risk

Increasing the IPO risks for Twitter, the company is also going public at a time when related social media stocks are trading at premium or even bubble levels of valuation. Facebook is trading at over 126 times its profit per share and 17 times its total revenue. LinkedIn (LNKD) trades at over 1,000 times its profits and 19 times its sales.

If Twitter prices at $25 per share, the top end of its current IPO range, the company will be worth about $14 billion, or 26 times its revenue. Twitter has yet to show a profit and didn’t offer a roadmap for reaching profitability in its recent closed-door presentations with big investors either, according to a report on Bloomberg.

The best deals tend to be those with the least amount of Wall Street excitement before the fact. Google (GOOG) went public in 2004 surrounded by the doubts and fears remaining from the three-year bear market that had just ended. In a subdued market, the shares rose just 18% the first day, to close at $100.34. With solid business results and growing profits, the shares gained from there, tripling within about a year and rising to over $1,000 this year.

But for Twitter, such a quiet debut isn’t likely. And for ordinary investors, that means the odds favor holding off.