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 Visa or MercadoLibre with a similar 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 new offerings just don't live up to the hype. Ask shareholders of Entropic Communications (Nasdaq: ENTR  ) , NetSuite (NYSE: N  ) , or Refco 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"
Needless to say, plenty of top investors don't find this situation intriguing. Warren Buffett is one. In Lawrence Cunningham's book The Essays of Warren Buffett (a book I highly recommend reading), the Oracle 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 offering 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 the 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's in the pudding ...
And we've seen this time and time again. What happened to investors who got in "early" on Vonage (NYSE: VG  ) and Fortress Investment Group (NYSE: FIG  ) ?

I'm not suggesting you always avoid new offerings. After all, at some point, all of my favorite businesses -- Morningstar (Nasdaq: MORN  ) , 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 Costco (Nasdaq: COST  ) and American Express (NYSE: AXP  ) 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 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 like 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.

Fool analyst Nick Kapur is always looking for the greatest companies, and he owns shares of Morningstar and American Express, as does The Motley Fool. Morningstar and Costco are Motley Fool Stock Advisor recommendations. American Express is an Inside Value recommendation. The Fool has a disclosure policy.


Read/Post Comments (3) | Recommend This Article (4)

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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 August 20, 2008, at 7:38 PM, Reindom wrote:

    I'm surprised they didn't mention VMWare. Their IPO was back in late August 2007. I got caught up in the prospects of this company. I work in the IT field and could see the value this technology can bring to companies. What I didn't separate, was the fact that market performance and a company's product or service don't necessarily coincide with each other.

    I finally conceded that I had made a mistake in July of this year, and sold VMW at a loss. In July the stock price had dropped to around $55 and was still trading at 100 to 125x earnings.

    The other deciding factor was another Buffettism I took to heart was, where will this company be in 10 years? With VMW, I don't have any idea, they could be around, or not, their pioneering technology 'should' be here, but Microsoft can throw more money at the technology than VMW or EMC. Even with an inferior product, MS could dethrone VMW. It's a coin toss in my opinion.

  • Report this Comment On August 21, 2008, at 3:02 PM, KWT8011 wrote:

    Fool, your own advertising tells me "Since 1970 Walmart is up 5300 times over its IPO"

  • Report this Comment On August 23, 2008, at 3:29 PM, jlccdMckTx wrote:

    Opinion For...

    The hype is expensive, even more when it comes from the mouths of gurus.

    Case in point: Global Crossing.

    Guru: George Gilder

    Recommendation: Mortgage the house.

    Outcome: Bankrupt.

    That didn't work out so well, did it.

    Opinion Against

    What was the name of that company behind the CDMA technology that helps us carry our little walky talkies around (cell phones)... Qualcomm.

    A few thousand dollars in this stock, and you would be retired.

    What needs to be mentioned about Qualcomm and Microsoft, for that matter, is that you didn't need to be there day one.

    There was plenty of time to research the stock, management, balance sheet, cash flow statement etc. Include Wal-Mart in this side bar.

    A "Get There First " mentality will lead to misery. There are no discounts on day one. Just a lot of unknowns with unsubstantiated prices.

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