Don't Buy the Hype

How did you possibly miss Google back when it was $100?

You remember that, don't you? The stock went public in August 2004, and BOOM -- that's all she wrote. What were you thinking?

My good friend hindsight, a clear 20-20, is telling me you seriously dropped the ball. You'd have multiplied your money by a factor of five in less than four years. I'd also wager that you're looking at last year's offering of MercadoLibre (Nasdaq: MELI) and its subsequent 62% returns with the same kind of regretful feeling.

Don't despair; there is a silver lining.

Forget the hype
These two companies have performed remarkably well thus far. In the real world, though, most of these offerings just don't live up to the hype. Ask shareholders of Orbitz Worldwide (NYSE: OWW  ) about this phenomenon.

When you're getting into a newly issued stock, you're really doing two things that smart investors don't like to do:

  1. You're investing in a company with lots of attention behind it. The likely consequence of excess excitement is a seriously questionable price tag.
  2. You're sending money to an unproven public entity. The company may have done fantastically when it was private, but everything comes under a little more scrutiny when it's public. Management may also not know how to properly allocate all of the money that comes in from the public offering and could blow it on wasteful projects. In short, there's rarely a track record at newly public companies ... and track records matter.

Buffett says "No"
Plenty of top investors don't find this situation intriguing. For one, Warren Buffett says no. In Lawrence Cunningham's book The Essays of Warren Buffett (a book I highly recommend reading), Buffett spells it out quite clearly: "The new-issue market ... is ruled by controlling stockholders and corporations, who can usually select the timing of offerings or, if the market looks unfavorable, can avoid an offering altogether. Understandably, these sellers are not going to offer any bargains, either by way of a public offering or in a negotiated transaction: It's rare you'll find x for 1/2x here."

He's not just arbitrarily avoiding these IPOs. Studies prove that IPOs and recent offerings just don't demonstrate long-term overperformance. According to one study from the University of Chicago's Graduate School of Business, IPOs experience brief flare-ups in price during their first three months of going public (thanks to the structure of certain regulatory and corporate events) but otherwise fail to show any kind of abnormal performance in the long run.  

The proof is in the pudding ...
And we've seen this time and time again -- several times already in the past year. What happened to investors who got in "early" on MF Global (NYSE: MF  ) and Blackstone Group (NYSE: BX  ) ? Both stocks are down about 35% in a year. Those investors could have afforded to wait a bit.

I'm not suggesting you always avoid new offerings. After all, at some point, all of my favorite businesses -- eBay (Nasdaq: EBAY  ) , for one -- were newly minted issues and have since rewarded shareholders well. If you have special insight into the business and you have a good understanding of the value you're getting at that price, then you should definitely go for it. Just remember this simple rule: New issues have no inherent advantage.

You must find value
Even if you're able to get your hands on a great business, you've won only half of the battle. You should be looking for great businesses at great prices. That's the trick. Buffett's crafty investments in companies such as Kraft (NYSE: KFT  ) (heh, get it?) and Nike (NYSE: NKE  ) reveal that strategy.

Before you buy, scrutinize new, hyped-up issues through the lens of a value hunter. What are you buying? And how much is it going to cost you?

Seemingly cheap situations aren't likely when you're sorting through the companies making exciting headlines. But the values are rampant in the quiet sectors, the otherwise neglected slices of the stock market where great investors such as Buffett thrive.

Discover where you can thrive
If this kind of approach sounds good to you, and you need a bit of a boost, I encourage you to check out our Motley Fool Inside Value investing service, where advisor Philip Durell and his team specialize in finding great business at great prices.

You can see their top picks for new money as well as all of their research and recommendations by joining the service free for 30 days. Click here for more information.

This article was first published May 5, 2008. It has been updated.

Fool analyst Nick Kapur is always looking for the greatest companies, but he owns no shares of any company mentioned above. Kraft is an Income Investor recommendation. eBay is a Stock Advisor recommendation. Google is a Rule Breakers pick. MF Global, naturally, is a Global Gains selection. The Fool has a disclosure policy.


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