Being politically correct has never been my strongest quality; therefore I’ll say this: I don’t feel sorry for Facebook’s new shareholders. Despite NASDAQ technical glitches and analysts sharing changes in estimates for the near quarter only with big clients, the Facebook initial public offering (IPO) was a success.
Yes, a success.
See, the IPO market in the US is rigged. It is used by the big brokerage firms to butter up their best clients — the ones that bring them the most business — and not [necessarily] to benefit the shareholders of the IPO company. This is Wall Street at its worst. The underwriters are supposed to represent the interests of their client, the IPO company (in fact they get paid handsomely to do so) but there is a conflict between the one-time fee they receive from the IPO company (plus, maybe, the fees they receive if the post-IPO company decides to seek their advice in future M&A activity) and the very predictable trading commissions that are trickling in every single day from their large brokerage clients. To rig the IPO for the benefit of the brokerage clients, underwriters create an imbalance between supply and demand by keeping the offering price significantly below the level where supply/demand indicates it will open. That way, the best clients get to own the stock for a few minutes or maybe a few hours, the stock jumps 20 to 50 percent, and they flip it for an astronomical annualized internal rate of return (IRR).
I know it will be hard for me to elicit any pity for the company’s founders — the newly minted billionaires and multimillionaires — but it required risk taking, a lot of creativity, endless willpower, and sleepless nights to build a company out of nothing. Private-equity and angel investors will get even less sympathy from you, but they took a risk and bet on something nascent. We see and envy their successes; but we don’t see their failure, which happen a lot more often than we think. The speculators that add little economic value make these insane (usually almost guaranteed) returns at the expense of insiders.
Vitaliy N. Katsenelson, CFA, is Chief Investment Officer at Investment Management Associates in Denver, Colo. He is the author of The Little Book of Sideways Markets (Wiley, December 2010). To receive Vitaliy’s future articles by email, click here or read his articles here.
Investment Management Associates Inc. is a value investing firm based in Denver, Colorado. Its main focus is on growing and preserving wealth for private investors and institutions while adhering to a disciplined value investment process, as detailed in Vitaliy Katsenelson’s Active Value Investing (Wiley, 2007) book.
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