COLUMN-Why IPOs are unlikely to produce long-term gains

Mon Nov 4, 2013 12:57pm EST

By John Wasik

CHICAGO, Nov. 4 (Reuters) - As the founders and backers of Twitter move toward the ultimate tweet - an initial public offering - it's a good time to ask whether IPOs are good investments.

Can the hot social media buzz surrounding Twitter be sustained for the company to survive a flame-out? While few can accurately predict future earnings growth, management decisions and whether the service can grow and gain more popularity, it's good to cast a cautious eye on IPOs in general and cast a wider net.

Keep in mind that Main Street and Wall Street investors may have entirely different takes on IPOs. Short-term traders may "flip" the stock after a few days - or even hours - and then move on. Individual investors may be gun-shy about owning IPOs after last year's botched offering of Facebook. It took a year for investors to recover from the company's initial price decline.

If you like small- or micro-cap companies for their growth potential, it would make sense to own a passive index of them. The iShares Micro-Cap ETF, for example, tracks the Russell Microcap Index, charging 0.72 percent for annual expenses. The fund is up nearly 37 percent for the year through Nov. 1 and holds companies like Methode Electronics, Multimedia Games Holding and Boulder Brands,.

For a much-broader based fund that holds small companies throughout the world, consider the SPDR S&P International Small-Cap ETF, which has gained 22 percent for the year through Nov. 1. The fund charges 0.59 percent for annual expenses and holds companies like Belimo Holding AG,, Shochiku Co and Rubis.

As with IPOs in general, although small-cap ETFs spread out the risk among hundreds of stocks, they are still much more volatile than their large-cap brethren. A fund like the iShares Microcap, for example, carries of five-year standard deviation - a measure of volatility - of 23, compared with 16 for the S&P index.

LONG-TERM RECORD TROUBLING

How well you can do with an IPO depends upon how long you hold it. The timing involved in selling it, though, can be nettlesome.

Over the short term, when investor excitement is high and the general investment climate stable, IPOs can produce some startling initial gains. When Netscape, one of the first Internet browser companies, went public in 1995, the offering price was $28. The stock soared to $174 by the end of that year.

But as the competition dug in, Netscape's market share cratered from 80 percent to less than 10 percent. By 2008, the company, long since absorbed by AOL, was pretty much kaput as a serious browser business. Countless IPOs have followed the same course, so it's wise to avoid wagering a big stake on an offering and instead choose a broad-basket index of small stocks.

What makes an IPO successful - at least in the short-term - is widespread optimism throughout the market and in the sector the stock represents. Internet stocks went gangbusters up until the dot-com bust of 2001. Are social media stocks headed for the same fate?

"IPOs can be a good investment, but usually they don't work out long-term relative to the market," says David Zuckerman, a certified financial planner in Los Angeles. "I typically try to persuade my clients not to buy them."

It helps to look at the sectors of the stocks being offered this year and try to gauge their long-haul appeal. Overall, it's been a strong year for IPOs, with 111 companies going public in the second and third quarters and another 11 going to market in the last quarter, according to Hoover's IPO Scorecard.

In the fourth quarter, biotech companies will dominate, with eight companies accounting for 14 percent of total offerings, followed by six software companies, comprising about 11 percent of the total offerings. The average value of fourth-quarter offerings is nearly $400 million, compared with $228 million for the second quarter.

One concern is that this latest wave of IPOs may be feeding off a bubble mentality - that is, the enthusiasm for new stocks may be over-valuing them. But when you look at price-to-book ratios, measures of a stock's market price to book value, maybe those fears are overblown.

The technology sector, for example, has a negative 15 price-to-book ratio. That compares with 45 for the overall healthcare sector, which has been popular this year with the introduction of the Affordable Care Act exchanges.

A low price-to-book ratio could indicate that a stock or sector is undervalued relative to the rest of the market. Although the price-to-book ratio is not a perfect measure of relative values, it may indicate that biotech stocks may be overpriced and tech stocks are a bargain.

There's even more risk in concentrating in one stock. It's nearly impossible to predict the course of stock prices in general; it's even more difficult to forecast the future of just one company, no matter how bird-like its appeal.

A couple walks along the rough surf during sunset at Oahu's North Shore, December 26, 2013. REUTERS/Kevin Lamarque

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