Disclosure: I am short IPO.
This is the sixth in a series of annual best ideas since the beginning of 2009. During that period, the S&P 500 approximately doubled. These best short ideas are down by a cumulative 70%. This is my best short idea for 2014.
It has been an exciting time for initial public offerings (IPOs). There have been over 200 IPOs in 2013, more than any year this century. It is no wonder that IPOs attract such excitement - they are brought to market at the precise moment that sponsors believe the public appetite to be at its peak. The marginal buyers are outside passive minority investors (OPMIs) while the marginal sellers are insiders who control the company and no longer want to own as much of the equity.
Insiders vs. Muppets
In such a transaction, whose side of the table do you want to sit on? This could be a tricky question, because one good answer is "the high priced helpers." The high priced helpers do extremely well during IPOs. Bankers charge fabulous fees to conduct the offering, traders make commissions far in excess of typical stock trades, and equity research/equity advertising efforts are at their most promotional. Top underwriters such as Goldman Sachs (GS), Morgan Stanley (MS), Bank of America (BAC), charge mean gross spreads of over 6% in the US or almost twice what underwriters charge in Europe. This difference in fees costs US issuers over $10 billion per decade. In fact, it is possible to get through entire conversations with bankers regarding how the IPO market is doing before realizing that they are talking only of the market for IPO-related fees as opposed to any consideration for the public investing in these IPOed securities.
Putting the Story in "Story Stocks"
The press is a willing accomplice as IPOs offer a new story. While "Lorillard (LO)… still public" would make a dull headline, a smirky 20-something IPOing a multibillion dollar tech company is news. However, like also called reality television, the reality is partially scripted and the drama is somewhat fake. Large market capitalizations implied by IPOs of small floats tend to get bid up by the most enthusiastic of enthusiasts. Combining the IPO process with innovative and technologically savvy companies leads to much enthusiasm to go around. Invariably described as "hot," the heat is a factor of the boiling point within a relatively small, self-contained group as opposed to the average or long-term demand of the market as a whole.
Why Do They Need the Money?
Not all IPOs are bad. The IPO process can be used by small, young companies that are seeking capital needed to expand a promising business. But it is always worth asking, "why do they need the money?" Among many of the most famous recent IPOs, it is not clear. Underwriting firms encourage privately owned companies to look at going public as a rite of passage, something to do for its own sake, regardless of whether the capital is needed.
Celebrate Good Times
Regardless of whether the sellers need the money or the buyers understand the equity, the combined might of underwriters, press, and their own egos confronting a rite of passage tends to suck everyone in to the IPO market. The language takes on the tone of carnival barkers, with each deal a "must-have," a "blockbuster" and the largest IPOs live on CNBC - every penny, every second. The sellers ring the opening bell and then… they party. Is there something a bit unsettling about the people who just sold you something celebrating the fact that they are rid of some of their equity and you - not they - are now holding the bag? Should they at least wait until they have accomplished something on your behalf first? Celebrate cash flow. Celebrate a growing book value. Celebrate cost savings. Celebrate a total return to shareholders over the long term, if you like. But celebrate dumping some stock on the public?
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They are partying because they used to own something… and now you do.
Insiders are selling and the public is buying.
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The FTSE Renaissance IPO Composite Index is outperforming the S&P 500 by over 20% in 2013. Until recently, there has not been a convenient mechanism for passively investing in IPOs. Renaissance Capital has run an actively managed mutual fund, the Global IPO Plus Aftermarket (IPOSX). In the spirit of IPOs, the sponsor has skimmed off just under half of the gross profits through fees, leaving investors in the fund with a net annual return of less than 3%. However, when there is excitement in the air, it is time for a new exchange traded fund (ETF). Enter stage left Renaissance Capital with their new IPO ETF (IPO), which tracks the most economically significant newly public companies. (click to enlarge)
New companies are included in the index on a fast entry basis on the fifth day of trading, or upon quarterly review, and are removed after two years when the IPOs become seasoned stocks. For insiders, this is a beautiful thing. Typical IPO lock-ups last between 90 and 180 days. Renaissance's self-imposed lock-up means that insiders have plenty of time to hit the door first. The top five positions include Michael Kors (KORS), Facebook (FB), Zoetis (ZTS), Delphi Automotive (DLPH), and Realogy (RLGY). Other notable positions include Zynga (ZNGA), SolarCity (SCTY), and Twitter (TWTR). Are these the type of securities that are unknown? Under followed? Out of favor? Unloved? As The Atlantic's Derek Thompson asked, "What, exactly, could you possibly know about Twitter that other people don't?" Here is his flowchart to help determine if you should buy TWTR:
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The same could be used for any other similar IPO. But do IPO equity buyers think that they are making an edgy investment? More likely, they are simply paying for a connection - however insignificant - to Elon Musk, Mark Zuckerberg, or Mark Pincus. The sellers are winners, so transacting with them makes one a winner too… in an incredibly minor and obscure way. The pieces of paper or bits of information representing securities serve the same role as medieval church relics connecting the people to their heroes, even when the relics are often sold and occasionally fake. But whatever the reason people buy them, how do they perform?
The long-run performance of IPOs is poor. From time to time, investors become overly optimistic in regards to the potential earnings of young growth companies. Those companies exploit the opportunity presented by such optimists via the IPO process. In the long-run, IPOs are durably overpriced. In the few years following IPOs - the same years captured by the new ETF - companies that sold stock in an IPO significantly underperform otherwise comparable firms. In short, an IPO can serve as a fad monetization scheme. From time to time, such fads are particularly popular, such as in 2007, 2011, and today:
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Backing up further, have IPOs ever had a better year? Switching to the older Bloomberg IPO Index, we can find only one year with better gains for IPOs... 1999:
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Here is what it looked like up close:
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At least in that instance, the reversion to making sense happens with rough symmetry to the upward frenzy. How long could today's frenzy last? It can last as long as insiders are locked up. Prices are high and time is short.
What about equities generally?
Investors and commentators are quite optimistic. We start with sentiment survey data in order to better understand participants' views of the market. These views are currently quite favorable towards equities. The ratio of market bulls to bears in the American Association of Individual Investors (AAII) is very high. At the same time, the amount that retail investors are allocating to cash is very low. The ratio of bullish to bearish sentiment among newsletter writers is at an extreme with the highest percentage of bulls since the late 1980s and the lowest percentage of bears… ever. The National Association of Active Investment Managers (NAAIM) survey shows a high net long exposure. Even the more bearish managers lack net shorts.
Optimism has shown up in strong flows into equity funds over the past few months. Investment Company Institute (ICI) fund flows reports indicate billions of dollars per week pouring into equity funds. This is dramatically different than the large selloff in 2008-2009 and the smaller one in 2011; in both cases, there were strong outflows from equity funds.
Meanwhile, according to Corporate Insider reports, corporate insiders have a high ratio of selling to buying. Based on non-public information, these insiders do not share retail investors' enthusiasm for their equities. Unlike retail investors, corporate insiders took advantage of price weakness by strong insider buying in both the 2008-2009 and in the 2011 opportunities.
Conclusion
The IPO market is expensive relative to equities generally. Equities generally are priced optimistically. To justify the price of the IPO, one needs a double dose of enthusiasm. As Charlie Munger says, "include me out." Our best short idea for 2014: the Renaissance IPO ETF (IPO).
Additional disclosure: Chris DeMuth Jr is a portfolio manager at Rangeley Capital, a partnership that invests with a margin of safety by buying securities at deep discounts to their intrinsic value and unlocking that value through corporate events. In order to maximize total returns for our partners, we reserve the right to make investment decisions regarding any security without further notification except where such notification is required by law.
By Chris DeMuth Jr.Source:http://seekingalpha.com/article/1897041-best-ideas-for-2014-short-ipo-and-or-its-components
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