Who are these rare winners, and are there enough of them to compensate for the losers?
Best Long-term IPOs
There are indeed some striking winners among newly issued companies. Table 6.1 lists the best-performing IPOs ranked by total cumulative return from the end of the first month of trading through December 31, 2003.
Intel, which went public in October 1971, is at the top of the list. Next comes Wal-Mart, the world’s largest corporation by total sales, and then Home Depot. All three of these firms enabled investors to turn a $1,000 initial investment into more than $1 million. These firms are followed by St. Jude Medical, Mylan Labs, Sysco (the food corporation), Affiliated Publications (purchased by the New York Times in 1993), Southwest Airlines, Stryker, and Limited Stores.
TABLE 6.1: IPOS WITH HIGHEST CUMULATIVE RETURNS PER DOLLAR INVESTED, 1968–2000
Table 6.2 ranks the ten IPOs with the highest annual returns of all those floated on or before 1990. By going back more than a decade, we eliminate those that have been recently issued that may have excellent returns for a few years but do not become long-term winners. Cisco Systems, issued in 1990, heads this list and has racked up an astounding 51 percent annual return, beating the benchmark small stock index by 38.6 percent per year. Cisco is followed by Dell Computer, issued in 1988, American Power Conversion, and Electronic Arts, the wildly successful video game manufacturer. Microsoft, which ranks twenty-second by cumulative return, ranks fifth with an annual rate of return of 37.6 percent.
Returns on IPO Portfolios
Now we return to the question of whether these huge winners, found in Tables 6.1 and 6.2, can compensate for the thousands of losing IPOs. The answer is found in Figure 6.2. It shows the differences in the returns between a portfolio that buys an equal dollar amount of all the IPOs issued in a given year and a portfolio that puts an equivalent dollar amount into a small stock index. Returns are computed from two starting points: (1) from the end of the month when the IPO was first issued, and (2) at the IPO offer price. All portfolios are held until December 31, 2003.
TABLE 6.2: IPOS WITH HIGHEST ANNUAL RETURNS, 1968–2000
The results are clear. For twenty-nine out of the thirty-three years, IPO portfolios underperformed a small stock index when measured either from the last day of trading in the month they were issued or from the IPO issue price.
Even the portfolio of IPOs issued in 1971, when Southwest Airlines, Intel, and Limited Stores all went public, trailed the returns on a comparable small stock index. This outcome also occurred in 1981, when the enormously successful Home Depot went public.
Even in the banner year 1986, when Microsoft, Oracle, Adobe, EMC, and Sun Microsystems all went public and delivered 30-plus percent annual returns, a portfolio of IPOs from that year just barely managed to beat the small stock index.
FIGURE 6.2: ANNUALIZED RETURNS ON YEARLY IPO PORTFOLIOS MINUS RETURNS ON SMALL STOCK INDEX, RETURNS MEASURED THROUGH DECEMBER 31, 2003
The only other years when the IPO portfolios managed to outperform the small stock index were 1977 (when St. Jude Medical was issued), 1984 (when Concord Computing went public), and 1988 (when Dell Computer was floated). Before the late 1990s, 1980 was the single worst year for all our IPO portfolios. In 1980 there were thirty-seven IPOs classified as oil and gas extractors. Not one of them managed to keep pace with the market, and twenty-four were eventually delisted through either liquidation or bankruptcy. Even though the oil bubble burst in that year, in 1981 there were fifty-four oil and gas IPOs, and their fate was no different. Again, not a single oil and gas IPO kept pace with the market, and thirty-five firms were liquidated or bankrupted.
The disastrous performance of the IPOs issued in the late 1990s during the technology bubble is readily apparent in the data. In 1999 and 2000, IPOs underperformed the small stock index by 8 and 12 percent per year, respectively, if measured from the IPO price, and 17 percent and 19 percent per year if measured from the end of the first month of trading.
During the late 1990s it was almost impossible for the average investor to buy technology IPOs at their offer price, and the prices jumped significantly when the stock opened for trading. The distribution of these coveted IPOs to favored clients meant billions of dollars of extra revenues to Wall Street. It is sobering that many “lucky” investors who were rewarded with these IPOs at their offer price lost all their gains in a few short years.
Risk in IPOs
Not only are the returns of the IPO portfolios poor, but the risk of these IPO portfolios is higher than that of a diversified portfolio of small stocks. The risk of the yearly IPO portfolio, measured as the standard deviation of returns over the next five years, was higher than the risk of the Russell 2000 small stock portfolio in every year since 1975. Since 1968, the risk of the IPO portfolio was 17 percent higher and since 1975 35 percent higher.
These results mean that investors who purchase IPOs not only are receiving a lower return than they would if they bought comparable small stocks but are also incurring more risk. It is clear that buying IPOs, like buying lottery tickets, is a losing long-term strategy.
The Hot IPO Markets
The absolute worst time to buy a newly issued firm occurs during hot IPO markets, when investors clamor to buy any new firms in the “must-have” industries. Hot IPO markets occur during bubbles, such as the technology bubble of the 1990s and the oil bubble of the late 1970s. In fact, a telltale sign of a bubble is a flood of initial public offerings, with prices jumping to hefty premiums when trading begins. These IPOs invariably give investors the worst long-term returns.
In a paper called “The ‘Hot Issue’ Market of 1980,” Professor Jay Ritter, the foremost academic authority on initial public offerings, documented that out of the initial public offerings from January 1980 through March 1981, the average first-day return of the seventy natural resource firms with sales under $500,000 was 140 percent.3 Virtually all these companies proved disastrous to investors.
Ritter also notes that following the oil boom, it was extremely rare for an IPO to double in price from its offering price in its first day of trading.4 Genentech doubled from its offer price of $35 to $71.25 in 1980, but for the next fourteen years there were only ten other IPOs that did so.
But 1995 changed all of that. Eleven companies doubled in value on their first trading day, more than the total in the prior two decades. The floodgates were opened on August 9, 1995, when Netscape, the first widely used Internet portal, sold 5 million shares through Morgan Stanley at a price of $28 per share. Netscape shares opened at $71 and traded as high as $74.75 before closing at $58.25 on a trading volume of almost 28 million shares. Although other stocks had increased more on the first day of trading, none drew the media coverage of Netscape.
In 1996 and 1997 there was a slight slowdown in the number of companies doubling on the first trading day, as only six companies accomplished the feat, including Yahoo!. But in 1998 the pace picked up yet again, with twelve companies more than doubling in price. Some of the more well-known (and well-hyped) included Broadcom, Inktomi, GeoCities, and eBay.
But doubling was no longer unusual. Owners of these Internet firms had greater heights to scale. On November 13, 1998, TheGlobe.com, which helped users personalize their online experience, went public at an IPO price of $9 a share and closed after the first day of trading at $63.50, an increase of 606 percent in one day.
But TheGlobe.com’s record wouldn’t last long. The next year, on December 9, 1999, VA Linux, a software developer (now VA Systems), went public at $3o, raced ahead to $320 on the first day, and settled at $239.25, up almost 700 percent in its first day, an all-time record.5
In total, in 1999 there were 117 IPOs that doubled on their first day of trading. This was almost three times the total of the previous twenty-four years. In the first nine months of 2000, seventy-seven more companies doubled on their first day of trading, before the bottom fell out of the tech bubble.
The next time you see these la
rge first-day price increases in the IPO market, be sure to stand clear. The higher the pop, the further the drop.
The Old, the New, and Creative Destruction
In Chapter 2 I showed that the new stocks added to the S&P 500 Index underperformed the older, original stocks in the index. In this chapter I’ve shown that the newest of the new stocks, the initial public offerings, also underperform a portfolio of seasoned small stocks.
These results raise an important question: if the old consistently outperforms the new, how does the new get created in the first place?
The answer is simple. The new firms are enormously profitable to entrepreneurs, venture capitalists, and investment bankers, but not to the investors who buy them. The public, in its enthusiasm to grasp the new, overpays for the very firms that drive our economy forward.
Burton Malkiel, the author of A Random Walk Down Wall Street, notes that “the major sellers of stock of IPOs are the managers of the companies themselves. They try to time their sales to coincide with a peak in the prosperity of their companies or with the height of investor enthusiasm for some current fad.”6 These entrepreneurs and venture capitalists dump a good part of their shares to the public soon after trading begins. Investors who think they are getting in on the ground floor of a great opportunity are instead about to fall through the basement.
The Founders, Venture Capitalists, and Investment Bankers
TELECOM MISADVENTURES
The Internet has been called the single greatest legal creation of wealth in the history of the planet. For the insiders—the founders who create, the venture capitalists who fund, and the investment bankers who sell—this statement certainly rings true. But just as Main Street investors were pouring their savings into the high-flying technology issues, insiders in many of the newly issued companies were selling their stakes. For the ordinary investor, the Internet is perhaps the single greatest legal (or not so legal) transfer of wealth from their savings to the pockets of others.
Examples abound of how the founders and the venture capitalists benefit while the investors crash and burn. Take Global Crossing, a telecommunications company that went public in August 1998 at a price of $9.50 and proceeded to rise to over $64 per share in the next seven months. At its peak in February 2000, the company was worth over $47 billion. Unfortunately for the stockholders who held on, all this value evaporated in the next two years as the company filed for bankruptcy in January 2002.
But many insiders didn’t hold on. Chairman and founder Gary Winnick and other directors made out quite nicely. Winnick sold approximately $750 million worth of stock before the company took its plunge—enough for Winnick to buy the country’s most expensive home (at that time) from billionaire and real estate mogul David Murdock in Beverly Hills, for $40 million. Winnick built up a reputation as being a big spender, with his philosophy that “money is no fun unless you spread it around.”7
Winnick didn’t spread it around to the outside shareholders, however. Six other members of Global Crossing’s board of directors, from the CFO to senior vice presidents, sold another $580 million in stock. But these gains were small change compared to early-stage venture capital investors. The Canadian investment bank CIBC World Markets turned a $41 million investment into a whopping $1. 7 billion. CIBC, fortuitously enough, sold its shares and jumped ship before the company sank. Loews/CNA Financial, owned by well-known real estate and hotel mogul Larry Tisch, also raked in $1.6 billion in profits from its early funding of Global Crossing and subsequent well-timed cash-out of 40 million shares.
And Global Crossing is just one example. At JDS Uniphase, insiders cashed out $1.2 billion; at Foundry Network, $700 million; at now-defunct wireless data provider Metricom, where yearly revenues never exceeded $18.5 million, more than $35 million in stock.8 According to a Wall Street Journal/Thomson Financial survey, telecom insiders directly cashed out over $14. 2 billion in shares during the bubble, and venture capitalists sold another $4 billion.9
THE VENTURE CAPITALISTS
Venture capitalists have helped launch thousands of companies, such as America Online, Sun Microsystems, and Genentech, that are household names.
The VCs had grandiose objectives for many of them, such as the goal of connecting every home in the country with high-speed cable Internet when At Home was launched in 1995. The firm went public in July 1997 at $5. 25 and attracted over 300,000 subscribers. But the directors and venture capitalists thought the company was not growing as fast as it could and needed to align itself with a content provider. At Home found a partner in Internet portal Excite, and At Home acquired Excite in a $6. 7 billion merger in June 1999, the largest-ever Internet merger up to that time, just after the firm hit its high of $99 a share.
At Home ranks as one the largest home runs ever hit by a venture capital firm.10 Public investors who held on to their shares were not as lucky, as the company went out of business in February 2002, rendering their shares, which were once worth $20 billion, worthless.11
Although the venture capital firms did far better than the investors in the Internet stocks, it would be wrong to blame them for the speculative bubble. They brought many fine and extraordinarily successful firms public. The venture capital firms never claimed that the shares of the companies that they had helped create were worth anything near as much as investors finally paid for them in the subsequent buying frenzy.
THE INVESTMENT BANKS
There is another group that makes a killing during the IPO mania, and that is the investment banks. The investment banks are usually paid a fee of up to 7 percent of the value of the IPOs they bring to the market.
From 1997 through 2000, over 1,500 companies were floated to the public markets. These IPOs raised over $300 billion in fresh capital for these companies. Given Wall Street’s commissions, we can estimate that the investment bankers pocketed up to a cool $21 billion for their efforts in bringing these companies public. Very few I-banks risk their own capital for these huge fees, as most IPOs are pre-sold long before they are released to the public.
But commissions are only the visible part of the pie that the investment banks receive. The bankers are able to allocate these sought-after shares to their favorite customers and friends and family. Since the offer price is often far below the price at which the shares start trading, the pop in price is pure profit to whomever they choose to give the shares.
From the difference between the offer price and the first-day trading price, I estimated that from 1997 through 2000 almost $200 billion of profits was spread to the investment bankers’ friends, family, and favorite (commission-paying) customers. Had you been lucky enough to be a preferred client of the investment banks leading TheGlobe.com’s IPO at its offer price of $9, you could have sold it as high as $63.50 on its very first day of trading. Many of the clients who received the shares cashed out their enormous gains quickly. If you are lucky enough to get a sought-after IPO at the offer price, the best advice is to sell it quickly.
IPOs with No Earnings and No Assets
The demand for the “new” reached such extremes during the Internet bubble that investors were reaching beyond the new to the unborn. Until the mid 1990s, firms that went public had several quarters of profitable operations behind them. This mold was broken when Netscape went public in 1995. Although the Internet portal lost money that year, its revenues were $85 million and rising rapidly. But as the Internet mania raged, there was increasing disregard for not only earnings but also revenues. This was a recipe for disaster. Professor Jay Ritter’s research has shown that the performance of IPOs with sales below $50 million has been horrendous.12
Consider the following examples. Sycamore Networks, which developed and marketed software-based optical networking products, went public on October 22, 1999. The firm attained a market value of $14.4 billion at the end of the first trading day. Sycamore had had sales of only $11.3 million in the previous twelve months and had an operating loss of $19 million. Akamai Technologies, which provided de
livery services for Internet content, went public a week later with a market value of $13.3 billion on sales of only $1.3 million while losing a whopping $57 million.
But the prize for the most highly valued—and overvalued—IPO goes to Corvis Corporation. Corvis, which designs products for the management of Internet traffic, went public on July 28, 2000. At the time of the offering, the firm had never sold a dollar’s worth of goods and had $72 million in operating losses. Nevertheless, Corvis had a market value of $28.7 billion at the end of the first trading day, a capitalization that would place it in the top 100 most valuable firms in the United States.
It is sobering to compare Corvis Corporation with Cisco Systems, which went public ten years earlier. At the time of its IPO in February 1990, Cisco was already a profitable company, earning a healthy $13.9 million on annual sales of $69.7 million. The market value of Cisco’s IPO at the end of the first trading day was $287 million, exactly one hundredth of the market value of Corvis, which had no sales, not to mention no profits.
To illustrate how absurd the valuation of Corvis was, if Cisco had been valued at the same $28.7 billion that Corvis was, its annual return, instead of being a record 51 percent per year over the next thirteen years, would have been below 8 percent, lagging almost four percentage points behind the overall market. This means even if Corvis had been as successful as Cisco in the next ten years (and earlier we saw that Cisco was the most successful IPO in the last thirty years in terms of its annualized return), it would still have been grossly overvalued.
The Future for Investors Page 10
