There Won't Be a Bubble 2.0

After investors slobbered like Pavlov's dogs for years over the inevitable Facebook IPO, its closest proxy finally made its big debut. Zynga (Nasdaq: ZNGA  ) , which derives nearly all its revenue from the social giant, recently began life as a public company worth $8.9 billion at a starting price of $10 a share. Strong interest was supposed to drive the stock to LinkedIn (Nasdaq: LNKD  ) heights, but its disappointing first-day performance seems like the surest sign yet that Internet Bubble 2.0 simply isn't happening.

A history of IPO madness
Today's IPO market is a virtual ascetic compared with 1999's googly-eyed lunacy, when Geeknet (Nasdaq: GKNT  ) , formerly VA Linux, popped like no other IPO before or since. Originally priced at $30 per share, the unprofitable company inexplicably closed its first day at more than $242, for a gain of more than 700%. It's now worth $17, which is really more than it deserves after remaining unprofitable for all but two years since going public.

The former VA Linux was hardly alone leading investors on a long ride down a bad road. In 1999, 115 companies doubled on their first day in a yearlong orgy of irresponsible offer pricing and slavering casino-style drunken speculation that may never be equaled in our lifetimes. Two years later, more than a fifth of the Class of 1999 had dropped off the exchanges. Of the remainder, more than half had lost 50% or more of their value.

A bad year for long-term holders, to be sure, but the history of IPOs is littered with early pops followed by longer-term drops. Less than a third of the annual IPO classes studied by Prof. Jay R. Ritter did well for buy-and-holders after going public -- the average three-year post-IPO return from 1980 onward lost out to the broader market's performance by 11%. However, most of them had nice debuts, rising an average of 14% on their first trading days.


Source: Prof. Jay R. Ritter, University of Florida.
Excludes REITs, closed-end funds, partnerships, and banks and S&Ls.
3-year return does not include ADRs. Returns tallied for all but class of 2010
.

Changing of the guard
The long-term average masks a more recent trend steering the IPO market away from its wilder excesses. In the decade since the dot-com crash, far fewer companies have gone public, and they've gotten better at producing viable returns. From 2001 to 2010, the average newly public company has outperformed the market by 4%.

Source: Prof. Jay R. Ritter, University of Florida.
Excludes REITs, closed-end funds, partnerships, and banks and S&Ls.
3-year return does not include ADRs. Returns tallied for all but class of 2010.

Despite the post-crash Dow's (INDEX: ^DJI  ) growth (it sported annualized returns over 10% for the five years after hitting bottom), the IPO market has yet to see anything approaching 1996, when nearly two companies went public every single day. More than four times as many companies, on average, went public each year from 1991 to 2000 as have each year since.

It's obvious something's changed. There are still occasional first-day doubles -- Quihoo (Nasdaq: QIHU  ) and LinkedIn are this year's outliers -- but since the wheels came off the party bus in 2001, only five others have reached such heights.

A generational shift
IPOs aren't necessarily supposed to outperform, but for much of the past decade, they have. Companies should be eager to go public to fuel their growth, but they haven't been. Something, at least for now, seems to have shifted.

The only comparable period is the flat market of the '70s and early '80s, when fewer than 600 companies went public in a 10-year stretch. Yet smart investors then, as now, have options for long-term greatness. FedEx (NYSE: FDX  ) has been an 80-bagger since its 1978 IPO, even before accounting for reinvested dividends. It's too early to say whether any of 2011's IPO class will reach those heights in 30 years, but there are some that could bring big rewards to patient investors.

Tech startups might be afraid of Bubble 2.0, but another factor affecting their desire to go public is an explosion of venture-capital funding. Last year, private companies got $23.7 billion in funding, which approached the $30.7 billion American companies raised in IPO proceeds during the same time. This year, venture capitalists could feed startups $30 billion in funding.

Zynga, as a prominent example, has raised $845 million in venture capital since its founding. A company with promising prospects rarely has a difficult time getting money to fuel its growth.

Far from foolproof, but much better than before
What's a patient investor to do with this more restrained IPO market? Zynga's tepid debut smells like bubble backlash, as the market remembers steep declines of the early aughts. It also recalls the hype machine that sent one-time darlings LinkedIn and Groupon (Nasdaq: GRPN  ) to big gains on their first days, despite long-term uncertainty over their core businesses.

Zynga's in a similar boat right now. It's lashed fast to Facebook, which it mentions 223 times in its most recently amended S-1 filing, and is reliant on a small percentage of fanatical users who buy virtual gewgaws. However, it's undeniable that these Internet stars, as well as most of the 2011 IPO class, have far stabler business models than most dot-com-bubble darlings. That doesn't make them great buys, though. The best IPOs are just as likely to be companies that fly under the radar.

Foolishly public final thoughts
The combination of easy venture capital, persistent bubble fears, and more accessible information has brought many popular IPOs to market at valuations indicating fully mature businesses. It's quite unlikely that Zynga will be a big gainer at its current price. How much bigger can a company with 227 million monthly gamers get? That's why I'm staying away for the time being and will be giving it a thumbs-down in CAPS until it can show that it deserves to be valued as richly as other online gaming champions.

Don't get caught up in the hype. Companies with years of history can be much better buys than the hottest IPOs, which is why The Motley Fool has put together a free report for our readers on what our analysts believe will be the top stock of 2012. Thousands have discovered its winning ways, and you can find out more -- get your free copy of this important report while it lasts.

Fool contributor Alex Planes holds no financial position in any company mentioned here. Add him on Google+ or follow him on Twitter for more news and insights. The Motley Fool owns, and Motley Fool newsletter services have recommended buying, shares of FedEx. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On December 24, 2011, at 10:08 PM, chawkinsIII wrote:

    Looking at this the wrong way. The reason these stocks are not doubling and tripling is because they are pricing the IPO's at unbelievable levels. You really expect Groupon to double with a market cap of 17 billion? I think simply pricing this thing at 17 billion is out of control. The ease at which startups can get millions from venture capital funds, to tv shows like Techstars (where everyone of those companies got funding), this is a bubble the equal of the dot.com years. And believe me, its going to end badly.

  • Report this Comment On December 24, 2011, at 10:31 PM, TMFBiggles wrote:

    I wouldn't call it a bubble because of the high valuations. As I said at the end of the article, I feel that the valuations reflect mature businesses rather than high-growth enterprises, which by itself should tamp down frothy expectations.

    I would never invest in Groupon at a $17 billion cap, or even at $7 billion, but the company does have a much more evident path to profitability than, say, VA Linux did at the time it went public. That's a big and important distinction. You might disagree with the company's business model, but at least it has a business model that's already been shown to produce a lot of revenue (if not yet profits). That's been the case of just about every major tech IPO this year, and should continue to be the case.

    Also, as a side note, I apologize for the mixed-up links. Not sure how it happened, as it looks completely random. Hopefully this will be fixed up after the holiday break.

    -Alex

  • Report this Comment On December 25, 2011, at 9:51 AM, gnulaw wrote:

    Re: GKNT FKA LNUX. Ken (NYSE:HD) Langone, CEO, GKNT announced a 1:10 reverse stock-split around November 8, 2010. So their current price of $16.18 was $1.62 pre reverse-split. It is also interesting companies like GKNT and PVSW are sporting relatively nominal market caps compared with virtually every start-up...the obvious implications being either one is very undervalued or Groupon et al are extremely overvalued.

    gnulaw covers GKNT here http://caps.fool.com/Blogs/ViewBlog.aspx?t=01005232244381733... .

  • Report this Comment On December 26, 2011, at 11:06 AM, Watchingmarcitz wrote:

    Well really the fundamental question is when is the true IPO? Yes there is the technical definition involving S1 filings and such but since the last bubble there has been the rise of the private company markets like SecondMarket and one could argue that Zynga amongst others started trading pseudo publically a long time ago. If you read the press on them in these markets they certainly behaved like the IPOs of yore. Zynga tripled in valuation in these gray markets in 2010/2011.

    This is what lead to the valuations that look like mature businesses. It really wasn't the VC investment but public mania done in a semi public way that lead to these "mature" valuations.

    The problem is there is no term for this and if you can't name it you can't track it. So I would like to propose a name. When a private company begins trading on a private company "gray" market like Second Market it should be called a PPO - PremonIntial Public Offering so that way we can still track it's valuation pop and call it a bubble when price swings outpace fundamentals.

    Http://watchingmarcitz.com

  • Report this Comment On December 26, 2011, at 11:16 AM, Watchingmarcitz wrote:

    Just to clarify the term is PPO - PremInitial Public Offering.

  • Report this Comment On December 27, 2011, at 6:48 PM, 102971 wrote:

    I'm afraid that the above comments are looking at IPO's in the wrong way. I, personally, have been involved in setting the offering price for a number of IPO's and I have always tried to set that price at a level which maximizes the amount to be received by the issuing company (or, in many instances, its existing shareholders) while looking for, maybe, a 5-10% increase in the price on the first day. Any underwriter that has priced an IPO so that it doubles on its first day has done a terrible job for the issuing company simply to benefit their Wall Street cronies. The speculators that received stock and are out on the first day with their ill gotten gains.

  • Report this Comment On December 28, 2011, at 9:11 AM, DJDynamicNC wrote:

    @102971 - that's a good insight, thanks for sharing that.

  • Report this Comment On December 28, 2011, at 3:24 PM, racchole wrote:

    I think the real lesson here is that public offerings of companies which provide little-to-no value to its shareholders, customers, or anyone else involved (Zynga being the prime example - a completely useless company which not even its customers would miss if it went away) should stay completely off the public market.

  • Report this Comment On December 28, 2011, at 7:03 PM, gilsh wrote:

    Or, maybe, we are in the middle of bubble 2.0, but it isn't a stock market bubble. It is a private equity bubble. how else can you explain corporations like groupon, linkedin and facebook getting pre-IPO valuations which have nothing to do with the stability and sustainability of their business model ?

  • Report this Comment On December 29, 2011, at 5:58 AM, Sunny7039 wrote:

    How does this indicate that there won't be a "Bubble 2.0?" It won't be in IPOs. It will simply have to appear elsewhere:

    http://harpers.org/archive/2008/02/0081908

    Actually, we don't even know whether there is a massive bubble somewhere right now, and there is some reason to suspect that there may be:

    http://www.clevelandfed.org/research/trends/2011/0811/02finm...

    "In contrast to the heavily regulated exchange-traded market, the OTC market is bound by little regulation and offers customized derivative products. . . . As a result, the OTC market is much larger than the exchange-traded market. For example, as of December 2010, the notional amount outstanding (the gross nominal value of all deals) in the entire OTC market, excluding commodity contracts, was $598 trillion, nearly nine times the amount outstanding in the exchange-traded market ($68 trillion)."

    The whole article is quite interesting. The author gets to credit default swaps at the very end.

  • Report this Comment On December 29, 2011, at 6:01 AM, Sunny7039 wrote:

    gilsh, I didn't see your astute comment before I wrote.

    If one thing is clear, it's that we have no clue what's really going on -- but you can be sure we will end up being on the hook for it.

  • Report this Comment On December 29, 2011, at 10:06 AM, TMFBiggles wrote:

    Well, folks, when I was referring to Bubble 2.0, I was focusing on the resurgence of Internet stocks, and comparing the original Internet bubble with what's happening today. Using the broadest form of this terminology, we had Bubble 2.0 centuries ago, and are on something like Bubble v. 28 (probably off on this one) or so.

    I would be pretty dumb to claim that there will never be another big bubble. I just don't think it will look anything like the Internet bubble from the 90's. So far, despite claims to the contrary, it clearly has not, and until we start seeing hundreds of fly-by-night hack operations with no revenues raising hundreds of millions, it won't. Private equity may seem overeager, but most of the companies raising seed capital still have a business model and a defined objective beyond "Internet's full of money! Want some now!" I'm sure there are some undeserving businesses with stupid ideas out there, but such businesses always exist and don't lead to a bubble unless there are more of them than real companies, as was the case a decade ago.

    @ Sunny7039 -

    OTC derivatives are dangerous products. I wish I had the space to cover everything that could become the next bubble (including derivatives), but it would be book length.

    -Alex

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