A distinctive feature of investors' recent fondness for social networking sites and other technology-oriented stocks, which some commentators have dubbed 'tech bubble 2.0', is the way many share prices have rocketed up in price on the first day of trading after their initial public offering (IPO) only to fall back dramatically in the weeks and months that follow.
While IPOs appear irresistible to many investors, we feel they should be treated with caution for a number of reasons. First, the people selling the business know far better than any buyer what it is worth. Since any sale is likely to take place at the time a seller considers most advantageous to them therefore, a decision to buy at that point is quite a statement.
Second, everybody involved in an IPO – the company, the investment banks and all the other advisers are incentivised to make it happen. As such, the sales machine is turned on full-throttle, which naturally leads to greater emphasis being placed on any positives rather than putting across a more realistic appraisal of the pros and cons of the business.
Furthermore, the company's management will have spent the previous couple of years preparing it for sale. In many cases, this may lead to their running the business aggressively in order to maximise short-term profits and cash while potentially under-investing in its long-term growth and, where this happens, the company may well struggle versus the competition in the period after the floatation.
Finally – and crucially – IPO investors have hardly any history on which to base their decision. At best, they will be able to draw on three years' worth of numbers. This means they cannot tell how a business has traded through a full economic cycle and, to muddy the waters further, people involved in IPOs have a habit of focusing on the stellar potential of future profits rather than the more concrete reality of current ones. Once again, that makes it very difficult to appraise the true benefits of the business.
Taken all together, those considering investing in an IPO will usually start from a position of weakness rather than strength. Add in further considerations such as the tendency for one company successfully coming to market to trigger a 'me-too' rush from similar businesses plus the very low 'free float' – the amount of shares actually available for trading – often involved in these deals and investors need be very careful indeed of the IPO.