Tags: Facebook | IPO | Market | Peak

Facebook IPO May Signal Market Peak

By Andrew Packer
Tuesday, 01 May 2012 09:28 AM Current | Bio | Archive

The average investor usually can’t buy shares of a company right at its initial public offering (IPO). That’s actually a good thing. Why? Because buying shares at an IPO is a recipe for disaster.

The key to understanding that is to ask yourself one question: Who benefits from the IPO? For starters, investment banks book billions of dollars a year in feeds. Secondly, the owners, who now have a chance to cash out. But cashing out means losing some of their ownership stake — meaning the price they get has to be above and beyond what they consider to be a reasonable value.

So why the buzz regarding Facebook’s upcoming market debut? The size? The valuation? The fact that markets are at a multi-year peak? If you answered all of the above, you’ve hit the nail on the head.

I honestly can’t blame the desire of Facebook’s owners to go public. Growth has been stellar. The stock market has been bullish for over three years. Initial investors are willing to pay about 170 times earnings for shares at the IPO price.

Not every IPO signals a market peak, but there are certain patterns. The first is big financial firms that have resisted the urge to go public in the past. In 1999, Goldman Sachs went public, less than a year before the market peaked. In 2007, Blackstone went public four months before the market peaked.

The second sign an IPO that may signal a market peak is when the service the company provides isn’t clear. At the height of the .com bubble, it wasn’t the size of IPOs that was staggering; it was the sheer number of companies going public with no earnings and no plan to make money for several years.

Today, it’s replaced by Facebook, a company whose revenues are dependent solely on ad revenue, and whose growth has already started to slow.

In short, the size and scope of the IPO market reflects the level of greed in the markets. It’s great for the owners to cash out at a high price, but those who invest in IPOs either need to quickly flip shares or sit through minimal returns. Facebook is big enough and priced high enough to signal a market peak in the next few months.

As investors, we want to stack the odds in our favor, not against us. When companies IPO, the insiders are essentially trying to cash out while demand is high. That puts the advantage to the sellers. The smart money is bailing out.

A better strategy is to buy shares when the company is unloved to the point where insiders are buying. Insiders have plenty of reasons to sell, but only one reason to buy: they expect higher prices.

Investing in a basket of companies where insiders are buying has historically outperformed the stock market by 6 percent to 9 percent per year. For investors, that puts the odds back in our favor.

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