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Question of the Week - September 22, 2014

Question of the Week - September 22, 2014

Guest Post - Monday, September 22, 2014

Should I buy into the hype of IPO stocks like Alibaba? How can I put the risks of an IPO into context for clients?

There was a good deal of hype around Alibaba, the 2nd largest IPO in history, raising nearly $22 billion, which pegged the total value of the company at $168 billion. The gain of over +30% in its first trading day may say something about the company's fundamental prospects, a mispricing of the offering itself or the underlying levels of investor excitement–only time will tell which.

As with any security, the question of whether to invest or not doesn't consist of one absolute answer, but a relative one. It might be first helpful to go back into the function of capital markets to lay out some perspective about why a company might want to go public in the first place, then evaluate the situation from there. (Hint: they're not doing it for your benefit or enjoyment.)

Capital markets, in this sense referred to as 'primary markets,' are, at their core, places for business owners to take their ownership stakes and monetize them–essentially, allowing a single, illiquid stake or group of stakes to be expanded into a broader, liquid and diverse set of stakes. This has been done for any variety of reasons: to raise capital for expansion (at perhaps a cheaper rate than through private financing), change a balance sheet's structure or improve its future flexibility, begin a succession plan for a company founder, enlarge the scope of a firm's public image (especially in the modern era), and/or create liquidity (such as when venture/private equity investors are looking to sell their early interests and move on, or to allow more attractive management incentives going forward, like stock option programs).

Skipping several important, time-consuming and expensive legal/regulatory/operational steps, the initial IPO price is generally set based on a variety of factors and is part art (investor sentiment and interest) and part science (valuation metrics), as pricing too low would bring in less capital than one otherwise could; pricing too high could result in low buyer interest and inability to fulfil the offering. The primary objective is to get as much of an issue sold as possible, so the IPO price is the mechanism for doing that.

Then the issue begins trading on the 'secondary market' (the major world stock markets we deal with) and proceed to trade by the fraction of a second least in theory. If the early investors are fortunate enough, the price goes up (often dramatically on the first day, if a high-profile and popular offering); but often, it doesn't. It's a bet, either way. We only hear about the headline-worthy offerings, but many new issues don't live up to the hype and offer quite disappointing initial year returns and many institutional portfolio managers avoid IPO's for this reason. But, pleasing investors really isn't the point of the IPO process–the purpose is raising capital for a company. It's easy to forget this in the frenetic trading of today's stock markets, but once the initial offering of shares is completed, the company doesn't directly benefit from the stock's market price after the money is raised (other than executive stock-option arrangements, intangible prestige from a stock's popularity, etc.) Making a profit by a rising share price is only a nice byproduct of investing in equities, to compensate for the equally-viable risk of loss (the forgotten reality is that a price falling to zero, resulting in a total loss, is the ultimate risk of any single equity, if conditions got bad enough).

Investing in an IPO requires some homework as it does with any already-traded stock. Unfortunately, a limited history doesn't offer clients a lot to go on, and these tend to be in 'new era' industries, so much of the implied value stems from potential for the concept to sustain itself and result in future growth in earnings, which is required to sustain the stock price. With financial modeling, especially in the future, small changes in inputs can result in largely variable outputs, so it's important to use care when reviewing any forward-looking data, particularly for new industries. Especially in new emerging industries and markets, as in the case of Alibaba, where underlying information about consumer markets is not always easy to come by. We get reminders of this every few decades or so, whether it be the auto industry of the 1920's or internet bubble of the 90's, where Main Street exuberance can compete with and sometimes overwhelm well-thought-out financial decisions.

Additional Reading

Read our Weekly Review for September 22, 2014.

Read the previous Question of the Week, September 15, 2014.

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