By Dan Crimmins
NEW YORK (AdviceIQ) -- The market offers you few morsels as tempting as stock in a household name's loud new public offering. Here's why to beware.
Social media company Twitter had its initial public offering Nov. 7. In an IPO, a private company makes shares available to the public for the first time. Twitter's headline IPO saw a well-recognized, 7-year-old, unprofitable company with more than 232 million monthly active users enjoying a ton of hype before the opening bell even rang.
Unlike in the IPO of fellow social-media mammoth Facebook, Twitter's early trading left many investors pleased with the initial stock increase. Will the price hold?
You must question picking the right IPO as the only way to reach your financial goals. Nothing's further from the truth for the average investor. Our firm doesn't recommend investing in the shares of IPOs for at least 12 months -- especially media-hyped IPOs for which demand for the shares pressures stock pricing.
Hot stocks, like all items subject to tremendous demand, cost more. Only through time does the push and pull of supply and demand eventually settle on what markets establish as the fair price.
When your philosophy of portfolio stock exposure calls for broad diversification in global markets, one additional company added to a portfolio with 10,000 or more holdings becomes less urgent. We add most new companies to portfolios eventually but see no immediate need to buy into the ballyhoo of any one company. Patient trading ensures a stock's proper categorization.
The noise often surrounding IPOs constitutes one reason we delay buying them. Our experience shows that the most sought-after IPOs tend to narrow their stock offerings; less-popular floats flood the market.
Aside from these practical short-term issues, studies also point to long-run underperformance of IPOs regardless of profits for speculators who sell quickly after nabbing discounted stock in the offer period. According to Jim Parker at Dimensional Fund Advisors, Tim Loughran and Jay Ritter's The New Issues Puzzle in the Journal of Finance ranks among the most referenced papers looking at IPOs issued in the preceding quarter-century. From 1995 to 2000, investors got average annual returns of only 5%, the paper reports.
Ritter, considered an IPO expert, updated that data to take in 1980 to 2008 in his paper Some Factoids About the 2009 IPO Market. He finds that firms with sales below $50 million tend to make a big splash upon a market debut then underperform larger counterparts. Small and large firms he examined underperformed average market buy-and-hold returns over three years -- smaller firms by a substantial margin.
Twitter may prove a good investment -- or not. A recent Forbes article points out that stocks generally close above the offer price on the first day's trading (as the dot-com bubble bore out), that investors who dive in on offering day see better returns if they hold the stock longer than six months and that original shareholders often surrender more than their fair share of the company to new stockholders in flashy IPOs.
Eventual stock value rides on the judgment of the market itself, not on marketing hype or blanket media coverage. That ride takes time. You and a good adviser should wait patiently for the judgment.
-- By Dan Crimmins, co-founder of Crimmins Wealth Management LLC in Woodcliff Lake, N.J. His blog is HREF="http://www.rootsofwealth.com/">Roots of Wealth.
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