The growth trap: One reason to be wary of tech IPOs

July 6, 2011

Stacey Hood had never bought stock before May 19 — the day LinkedIn debuted on the New York Stock Exchange. Suddenly Hood dove into the market.

Enthusiasm for the professional networking site was so strong that LinkedIn opened trading at $83 a share even though the company had priced its initial public offering at $45. Hood snapped up 10 shares at $82, sat back and watched the LinkedIn stock ticker dance. More than 30 million shares traded hands that day, pushing his investment past $90, $100, $110 and even $120. He got out at $121.70 — for a $400 profit.

“It’s kind of like gambling,” said Hood, a 44-year-old telecom marketing executive in Birmingham, Ala. By mid-June, the shares had dipped to $60 per share, underscoring the importance of seizing the moment and moving quickly when tech IPOs hit the market.

As the stock market rounds up a long list of anticipated IPOs — including coupon provider Groupon, gamemaker Zynga and social-networking giant Facebook — it’s undoubtedly tempting to follow Hood’s lead. The market for these stocks is hot. They seem poised for tremendous growth. With many retirement portfolios still reeling from the financial crisis, it may not seem like a bad way to make up some lost ground.

But there is a fine print on that temptation, say finance professionals and advisers, and it goes something like this: Unless you have the nerve to make a quick, lucky gamble as Hood did, IPOs of high-growth Internet stocks are likely to be such a rotten investment that you’re better off parking your money in something old and boring, such as a Coca-Cola or a General Electric.


Illustration by Bill Mayer
Price matters

Jeremy Siegel, a finance professor at the Wharton School of the University of Pennsylvania and author of “Stocks for the Long Run,” has a term for this oft-neglected irony of high-growth investing. He calls it “the growth trap.”

“The growth trap is the belief by investors that they should buy the companies that have the fastest earnings growth,” Siegel said. “The trap is they don’t pay enough attention to the price at which they’re paying for this growth.”

It’s akin to buying a house in a stable neighborhood where the price accurately reflects both the upside and downside risk. Say you pay $100,000 in hopes of having it appreciate $50,000 once demand peaks. If all goes according to plan, you make 50 percent on your investment. On other other hand, if it’s a hot, up-and-coming neighborhood where the speculators have already bid up values, you might have to pay $200,000. You can still profit if your $50,000 bet pans out, but the return on your investment is now 25 percent.

Investors make this mistake all the time, Siegel said. “The historical evidence is very overwhelming that investors overpay for growth,” he said, pointing to shares of computer maker IBM and oil giant Exxon Mobil as an example.

IBM was the Facebook of its time in 1950. The computing revolution was imminent, and its shares were poised for much faster growth than Standard Oil of New Jersey, Exxon’s predecessor. Had you invested $1,000 in IBM in 1950, you would now find your investment worth 33 percent less than if you were cashing out Exxon Mobil shares, Siegel said. As far as earnings per share, investors in Jersey Standard finished almost three-quarters of a percentage point ahead.

“Although the difference is small,” he said, “when you opened your lockbox 601 / 2 years later, the $1,000 you invested in the oil giant would be worth $2,928,547 today, while $1,000 invested in IBM would be worth $1,979,370.”

“IBM was a much faster-growing company on earnings, on sales, by any stretch,” Siegel said. “But Exxon Mobil gave better returns to shareholders because its price was much more reasonable.”

So what’s a modern-day equivalent to the IBM-vs.-Exxon choice? Siegel doesn’t have one at the ready, but Tony DeSpirito, a portfolio manager at New York-based Pzena Investment Management, does. He pits computer maker Hewlett-Packard against LinkedIn to show why value investing, or picking a stock based on its value relative to its earnings, makes sense in today’s IPO-crazed environment.

Scarred by a scandal involving its former chief executive and trounced for a reduction in its earnings guidance, HP’s shares are now trading at about eight times their earnings. DeSpirito considers this cheap, given HP’s “blue-chip market franchises” in computer manufacturing, printing and server products.

“Everything could go wrong, and the stock could still be fairly valued at worst,” DeSpirito said. He’s bought 13.3 million HP shares for Pzena in the past year, a stake worth about $545 million, according to a regulatory filing.

LinkedIn, on the other hand, may be the leading Web site for professional networking. But at its recent price of $88 per share, investors would have to pay more than 1,200 times its earnings to benefit from its growth, according to data provider Bloomberg. DeSpirito hasn’t bought a single share.

“The problem with a stock like LinkedIn is it becomes priced for perfection,” DeSpirito said. “Everything has to go right for the company for it to grow its way into the valuation.”

“And that’s the problem with growth investing,” he added.

Not all professional investors are staying away from LinkedIn. Los Angeles money manager TCW bought more than 6,400 shares of LinkedIn across four of its growth equity funds, according to fund data provider Morningstar.

Citing legal restrictions, Brendt Stallings, manager of TCW’s growth equities strategy, declined to comment on specific stocks. But he said growth investing as an investment approach still makes sense despite the “frothy” IPO market.

“The reason why we love being growth investors,” Stallings said, “is if you can find the company early in its life able to grow their revenues 15, 20, 30 percent annually for several years and expand their operating margins, that is actually very attractive.”

Playing it safe

Individual investors dead set on participating in IPOs of fast-growing Internet stocks have a couple of ways to limit their risk. One is to get in early, which is easier to do these days thanks to a new market being developed to buy and sell shares in privately held companies.

Steve Seay, a recruiting analyst in Houston, found this out recently when he asked in a May 28 LinkedIn posting, “Who knows how the ‘average’ person can invest in the big social media IPOs coming down the pipeline[?]” Within days, he had replies from several brokers offering to sell him “pre-IPO” shares of companies such as Facebook from employees who want to sell holdings.

“I feel like I did get some viable responses,” said Seay, 61. But he said he would have to do more research on the sellers and get some legal and tax advice before buying such shares.

Bigger investors can also buy such shares through Web sites such as SharesPost that regularly hold auctions of shares in private companies such as Twitter and Facebook.

But buying shares this way can be risky, said Jeffrey Ladouceur, a wealth adviser with SEI Wealth Network in Oaks, Pa. The secondary market for such shares is not very transparent, and it entails regulatory risk because securities laws limit the selling of private shares to individual investors beyond a certain threshold. “It’s probably not the right way to go,” Ladouceur said.

A safer route may be to wait for a company to go public but to be selective about which IPOs to participate in. “The most reliable indicator of whether a given IPO will be a good long-run investment is whether the pre-IPO annual sales were higher or lower than $50 million,” said Jay Ritter, a finance professor at the University of Florida who studies IPOs.

Ritter bases this finding on a sample of 7,354 IPOs that took place between 1980 and 2009. He found that companies that had pre-IPO sales of $50 million or more did much better than those with sales below that threshold, earning an average 39.1 percent buy-and-hold return vs. 5 percent over a three-year period.

“In retrospect, the vast majority of companies that have gone public with low sales were not ready to be public companies,” Ritter said.

Meanwhile, stocks that double in value on their first day of trading, such as LinkedIn, are more of a mixed bag because early performance is not a reliable predictor of future returns, Ritter said.

The one exception? The Internet bubble of 1999 and 2000, in which the larger the first-day jump, the bigger the subsequent fall. “Whether we are in Internet bubble 2.0,” he said, “is an open question at this point.”

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