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IPO Stars Lifting Mediocre Brethren

Kevin Kelleher

The hits keep on coming from the tech IPO market: athenahealth surged 97% on its first day in the market. Compellent Technologies rose 79%, VMWare (VMW Quote) jumped 76%, China Digital TV climbed 75% and Constant Contact (CTCT Quote) ran up 73%.

All of these IPOs debuted in the past three months -- a very choppy period for the stock market in general. Three of them debuted this month alone. And if you throw in Alibaba -- the Hong Kong IPO scheduled for next week that is so oversubscribed, it's certain to see a huge first-day pop -- you're seeing what I consider a rather disturbing trend.

Sure, lots of people love those first-day pops. For journalists, they make for good headlines. For companies going public, they generate free and positive publicity through those same headlines. And for underwriters, they stir up interest in the IPO market, paving the way for more deals.

Fair enough. But I can't help think that we're starting to see too much of a good thing. Renaissance Capital tracks aftermarket data on its IPOHome site, and crunching the numbers I found some interesting trends.

Since July 1, companies going public have risen an average of 19% on their first day of trading. That's more than twice as much as the 9% average first-day gain in the first six months of 2007. Lest you think that things are quieting down, consider this: In October alone, the average first-day pop was 27% over the offering price.

That means that IPOs in October have been, on average, priced at a significant discount to what the market thought they were actually worth. If the stock market is truly an efficient, self-interested beast, then that's an awful lot of money that easily could have been raised but was left on the table instead.

And that can be explained only two ways: Either underwriters were stupid in valuing these deals or they were very cunning.

I'm inclined to favor the cunning theory. These first-day pops have happened so consistently that you'd think the bankers might realize they're setting the bar a little too low on deals that won rave reviews on the road.

Anyway, you don't get to work on the investment banking desks of Morgan Stanley, Goldman Sachs or any of the other big boys, let alone get handed a hot IPO, if you're not terribly bright.

Besides, executives at these new companies, who still own a good chunk of stock in them, have seen their own net worths improve, so they're unlikely to complain.

Some people might point to many recent IPOs that haven't done as well and thus argue that the market is still being rational.

But it's not being rational at all. It's being irrational in a very focused, clever way.

Once word spreads -- as it is with deals like China Digital TV and VMWare -- that well-run, profitable and promising companies are going public and seeing their stocks surge madly, IPO mania comes back.

And once it does, second- and third-rate companies come crowding into the pipeline. Supply of shares surge because the demand to meet it has also surged. So underwriters start pushing out crappier companies to a market overcome by nervous excitement and agitation.

And the underwriting fees on those deals will pile up.

It's not clear yet that this trend of IPOs with first-day price pops will blossom into a full-fledged mania. The stage has been carefully set, and now all we need is for the investors and pundits to start reciting the lines like, "It really is different this time," and, "Buy the stock today because profits will be huge in three years."

But judging from what we're seeing so far in the reaction among investors to these recent IPOs, it sure seems like it's all proceeding according to that old script.

I suppose it's time to insert the obligatory note here that the underwriting system is hurting the little guy. So yes: Small investors are the ones being shut out. They can watch a video feed of the roadshow, but they can't easily get a sense of demand for a deal.

Nor are they usually allowed to buy at the offering price. Despite the noble efforts of W.R. Hambrecht to push the open IPO format, it remains marginal. Even Google , which offered much of its stock to all comers in its IPO, limited its secondary offering to the big boys.

And it probably isn't fair. But nobody worries about the little guy as long as the market is heading higher -- including, and especially, the little guy himself. It's only after it comes crashing down that people start sticking up for him.

But honestly, if the little guy hasn't learned his lesson after the dot-com bust and the woes in real estate, what's it going to take?