Buy Facebook? Wait Until Next Year

During the 18 years that I have been a professional money manager, I have witnessed a lot of Initial Public Offerings. I have seen some good ones, and a whole lot of bad ones.

I have learned to avoid IPOs unless I think they are an outstanding value, and that rarely is the case. Did you know that over the long haul, IPOs have underperformed the market by a wide margin?

Yes, I remember 1999 and 2000, when IPOs last hit a feverish pitch. It seemed that all a company had to do was get their venture to an initial public offering and everyone would cash in. Many IPOs during that time period would have insatiable demand by individual investors and normally rocket higher after the initial offering. Nevermind valuations, the company had a dot.com after the name, and they now were selling their goods on the internet. What more do you need?

I can still remember when K-tel announced in 1998 that they were going to expand their music business to the internet. The stock shot up from $3 to $7 per share in one day. The stock eventually peaked at $34 per share a few months later as an extraordinary short-squeeze ensued.

The company completed a 1 for 5,000 reverse stock split at a later date,  and was eventually de-listed. Imagine owning 10,000 shares and waking up with just 2 the next day! K-tel is just one of numerous examples of stocks that investors completely ignored the valuation on during that frenetic time in the market.

In the weeks leading up to the Facebook IPO, I had a number of clients ask me if I would be buying it. My answer was that I had absolutely no interest whatsoever, and here is the reason why:  I have found over the years that it is best to combine performance with value in evaluating a stock. I am neither a value investor, nor a performance (momentum) investor -- I am both. I have written many articles on this subject, including this one.

As we learned during the go-go years of the late 1990s, the stock market’s valuations eventually come home to roost. It was not uncommon during that period to see many triple-digit price-earnings ratios. Would you pay 150 times earnings for a local dry cleaning business that earns $50,000 per year? At a valuation like that, you would be paying $7.5 million for $50,000 in earnings. Oh, I know, what about growth? But still, $7.5 million?

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