Facebook IPO buyers deserved to lose

Buying into an overhyped initial public offering is like playing the lottery.

The outcry over the pounding that Facebook IPO investors took might lead you think this was an unusual event. You would be wrong. Initial public offerings, especially those preceded by lots of hype, have long histories of burning shareholders, who rarely understand their low odds of success.

This fact seems little understood, despite the vast amount of research that supports it. University of Florida finance professor Jay Ritter, for example, has studied IPO performances for years. His findings suggest that IPO buyers are like rock climbers with frayed ropes. Examining 1,006 IPOs from 1988 to 1993, he found that the median IPO underperformed the Russell 3000 index of small-cap stocks by 30% during the three years after the offering. At the end of that period, 46% of the stocks were below their IPO price. Piper Jaffray, working for U.S. Bancorp, conducted a similar study, looking at 4,900 IPOs from May 1988 to July 1998. This 10-year period was great for the market: the S&P 500 gained 472%. But new IPOs didn’t keep pace. Fewer than one-third of the newly public businesses were trading above their IPO price by the decade’s end.

Some might assume that IPO winners easily offset the losers. There’s the story of Microsoft, up nearly 31,000% since its 1986 IPO. Then there’s Google which, according to Morningstar, has gained more than 400% since its 2004 public debut. But dreamers believing that blockbuster IPOs are the tickets to financial freedom need to examine the bigger picture.

Outsized IPO gains, according to Wharton Finance professor Jeremy Siegel, are rare. In a study covering 1968 to 2003, Siegel found that IPOs underperformed the small-cap stock index 29 out of 33 years. In his book The Future for Investors, he argues that “investing in IPOs is much akin to playing the lottery.” After tracking the performance of nearly 9,000 IPOs, he concluded that they’re a great deal for the investment banks that underwrite them but usually a terrible deal for regular investors.

This is a long-term trend. Siegel notes that 80% of IPOs during the period he studied underperformed the small-cap index since their IPO date. In fact, IPO investors lagged the S&P 500 by 2% to 3% per year. What’s more, the worst-performing initial public offerings tended to be those companies on which investors pinned the highest hopes.

The fact is, the world’s most profitable IPOs weren’t storybook stocks like Microsoft or Google, but dull businesses that didn’t open at silly prices. Fastenal, for example, provides building supplies. Since its 1987 IPO, which occurred a year after Microsoft’s, its shares have gained about 1,000% more than Bill Gates’s company.

Sexy stocks like Facebook are generally absent from lists of IPOs with the highest cumulative returns. Siegel compiled the 10 best-returning initial public offerings since 1968, measuring their overall stock and dividend gains to the end of 2000. The winners included Wal-Mart, St. Jude Medical, Mylan Labs and Limited Stores. The only tech company that made the cut was Intel. Popular businesses fetch expensive prices at IPO, which may please the founders and underwriters, but routinely leaves the little guy dangling.

Were investors overpaying for Facebook? Almost certainly. It opened with a P/E ratio exceeding 100 times earnings. In other words, if you bought the entire business at the opening price of $38 per share and kept all its profits, it would take more than 100 years to recoup the money you spent on the company, assuming it earned $720 million a year (as reported in 2011). Buying Facebook at 100 times earnings is like an NHL hockey team paying $100 million for the future signing rights to a gifted eight-year-old right winger. In both cases, investors pay heavily for uncertain promise.

So when the next overhyped IPO comes along, should you bother? I don’t think so. Not unless you like scaling shale walls with frayed ropes.

Andrew Hallam is the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School