“A lot of other people are trying to be brilliant,” Charlie Munger told the 2017 annual Berkshire Hathaway shareholder meeting. “We’re just trying to be rational.”
Like many insights from Warren Buffett’s right-hand man, it was tossed casually into proceedings and yet, if rationality were really so easy, then value investing, which relies on the irrationality – the fear and the greed – of wider markets, would arguably not even exist.
Still, amid some stiff competition, one area of investing strikes us as especially irrational and that is the initial public offering or ‘IPO’.
The IPO - approach with caution
Nor, despite the slew of businesses coming to market at present, is this a new concern – look back eight years to one of the earliest pieces to appear on The Value Perspective, Fear of the new, and you will find a number of reasons why we believe IPOs should be approached with caution.
One of these is the simple fact the people selling the business know far better than any buyer what it is worth – and thus are likely to be coming to market at a time they consider most advantageous to them.
Another is that everybody involved in an IPO – the company, the investment banks, the myriad of other advisers – are incentivised to make it happen, which can see an undue emphasis being placed on the business’s positives.
Crucially, IPO investors have hardly any history on which to base their decision – at best drawing on three years’ worth of numbers.
As we observed back in 2011: “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.”
On occasion, a disinclination to focus on concrete reality can be taken to extremes – as illustrated by this recent Wall Street Journal article, which highlights the “sloppy” IPO filings of office space company WeWork. “The details that were wrong or omitted from its financial disclosures played a part in weakening investor appetite and will pose risks if the company ever tries to go public again,” the piece argues.
According to the WSJ, such details included leaving unanswered “some basic questions about the company’s finances” and not being clear on some important governance issues.
“Several metrics that analysts and investors said were crucial to assessing how the company’s breakneck growth is affecting its profitability and cash burn weren’t disclosed in the prospectus,” it adds.
Some IPOs are hard to appraise
All things considered then, it can be very difficult to appraise the true benefits of any business ahead of an IPO.
And while we are by no means arguing any of the above concerns necessarily apply to any particular floatation, it is hard to imagine investors who bought in on day one of the very high-profile IPOs of recent months being thrilled by what, in some cases and thus far, have been pretty low-profile returns.
As of the end of October, for example, Uber had seen its shares fall about 20% since its May IPO while fellow ride-share operator Lyft was down 45% since floating in April.
For its part, exercise business Peloton had already fallen 10% since it floated at the end of September – a month that also saw global entertainment business Endeavour pull its IPO plans, not to mention WeWork, as we discuss in more detail here.
All five of those businesses where prominent ‘unicorns’ – that is, unlisted start-ups that have reached a paper valuation of at least $1bn (£777m) – and some potential causes and ramifications of such companies’ recent performance are analysed in an interesting Markets Insider piece headlined The IPO market is rebelling against many of 2019’s money-losing unicorns.
Weak margins, the macroeconomic landscape and branding all come under the microscope before the piece concludes: “Recent unicorn performance is sure to have investors, analysts and executives questioning the future of start-up IPOs. Hype built in private funding rounds is mattering less in public markets, and investors are less willing to overlook poor margins.”
“No matter the path to markets, firms are seeing greater public scrutiny toward their financial figures,” it goes on, before quoting one expert arguing the “honeymoon phase of post-IPO pops” will end, with companies needing “a clear path to profitability” if they want to transition from private funding to public markets. “Toward the later rounds, private investors will have to be more rational in what they’re willing to pay.”
If the recent run of disappointing unicorn floatations ends up encouraging IPO investors to be more rational about where they direct their money, that really would be brilliant.
All stocks mentioned are for illustrative purposes only and not a recommendation to buy or sell.