Why Facebook's IPO shouldn't excite you

Fortune magazine's managing editor, Andy Serwer talks to Charlie Rose, Gayle King and Erica Hill about what we can expect from Facebook's expected IPO.

The investing world certainly seems to be working itself into a frenzy over the looming Facebook IPO. But before you jump in thinking you finally have a way to make real money from FarmVille and Words With Friends, you had better know your history.

Many people can point to Google as an example of a tech company making investors rich. The IPO set the share price at $85 a share, with the price now around the $580 mark. However, just consider some other recent IPOs.

LinkedIn saw its share price climb as high as $122 on its first day and then settled at $94.25 on that day, jumping up from its $45 initial price. Remember that most of those gains aren't experienced by individual investors, but by institutions that get the first crack at the stock. Those who jumped in after the first day have likely been disappointed, as the stock currently trades around $72.

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Zillow saw a similar spike during its July IPO of trading as well. The company priced its IPO at $20 per share, with the stock ending its first day at $35.77. The stock currently hovers around $30. Pandora offered its shares at $16 when it went public in June. Now, the stock trades around $13.

Of course, these are recent, isolated examples, and investors shouldn't jump in without understanding how IPOs have performed historically. Let's look at the reality of actual performance of IPOs:

University of Florida finance professor Jay Ritter looked at 1,006 IPOs that raised at least $20 million from 1988-1993. He found that the median IPO underperformed the Russell 3000 by 30 percent in the three years after going public. He also found that 46 percent of IPOs produced negative returns.

Another study examining the performance of 1993's IPOs through the period of mid-October 1998 found that the average IPO had returned just one-third as much as the S&P 500 Index. Amazingly, more than one-half were trading below their offering price, and one-third were down more than 50 percent.

A U.S. Bancorp Piper Jaffray study covering the period from May 1988-July 1998 and 4,900 IPOs found that less than one third were above their IPO price by July 1998. In addition, "almost a third weren't even trading any longer (having gone bankrupt, been acquired or no longer trading in an active markets)."

A study covering the period 1988-1995 and 1,232 IPOs found very similarly disappointing results with 25 percent of all offerings actually closing the first day of trading below their offering price. The study also found that the IPOs defined as "extra hot" -- meaning they rose 60 percent or more on the first day of trading -- were the very worst performers going forward: Over the next year they underperformed the market by 2 to 3 percent PER MONTH.

1999 was a spectacular one for IPOs with 555 companies raising a record $73.6 billion. The amount raised surpassed the previous record, set in 1996, by almost 50 percent. For all IPOs the median first day performance was 30 percent. However, investors who bought at the first day's closing price didn't do nearly as well. The median increase after three months was 0 percent, meaning that half of all issues lost money. Even more amazing, nearly 75 percent of all U.S. Internet-related IPOs since mid-1995 were trading below their offering price at the time of publication.

In the face of this poor performance, why do investors continue to chase the latest IPO? I believe there are two explanations for this seemingly irrational behavior:

First, unless an investor happens to read scholarly publications such as the Journal of Finance, he or she is unlikely to be aware of the facts. Second, even when informed, investors often act in what appear to be irrational ways. In this case I believe it to be another example of "the triumph of hope over experience." Investors seem to be willing to accept the high probability of low returns in exchange for the small chance of a home run or, possibly even more important, a great story to tell at the next cocktail party.

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    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

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