Should you get in on a hot new restaurant IPO that's almost guaranteed to generate double-digit revenue growth for years to come? While it seems tempting in theory, actually doing so may be a bad idea.
Shake Shack is going public
Last week, Shake Shack, a popular New York City-based burger joint, announced that it has decided to go public. If the reception to the news on Twitter and throughout the financial media is any indication, it will be a highly coveted affair.
Founded in 2001 as a hot-dog cart in New York's Madison Square Park, the concept has expanded to 63 physical locations, 32 of which are licensed to domestic and international operators. Meanwhile, its systemwide sales have gone from $21 million in 2010 to $140 million in 2013.
It goes without saying that there is phenomenal potential for a company like this. Yet determining whether such potential will translate into outsized returns for early investors is far from obvious.
According to Benjamin Graham, the father of value investing and author of The Intelligent Investor, the answer is generally no:
Our one recommendation is that all investors should be wary of new issues -- which means, simply, that these should be subjected to careful examination and unusually severe tests before they are purchased.
The data on IPOs
While the data on the performance of IPOs isn't conclusive, it tends to support Graham's warning. Over the past five years, for instance, a composite of IPOs compiled by Renaissance Capital has returned a total of 124%, compared with the S&P 500's 132%.
And data curated by Professor Jay Ritter at the University of Florida leads to the same conclusion. Between 1970 and 2012, Ritter found that IPOs underperformed similarly sized publicly traded companies in the first, second, third, and fifth years after listing. The only outlier, for reasons not immediately apparent, was the fourth year, in which the cumulative return of newly listed companies exceeded that of their similarly sized competitors by 1.8%.
This isn't to say that the data speaks unanimously against IPOs, as there is conflicting evidence that suggests the opposite. Most notably, an IPO index designed by First Trust, a money management firm headquartered near Chicago, has returned a total of 150% since 2006 versus the S&P 500's total return of 92%.
And, of course, it's hard to ignore the companies that have gone public and seen their shares soar. Digital-camera maker GoPro, which listed in the middle of last year amid its own flurry of media attention and excitement, serves as a case in point. Since opening at $28.65 a share on June 26, its stock has more than doubled in price and currently trades for more than $65 a share.
The issue with IPOs, in turn, isn't that none of them pay off. As GoPro and others have demonstrated, some do. The issue instead is that they aren't designed to do so -- or, at least, not for the individual investor.
IPOs and the lemon problem
In the first case, you have the so-called lemon problem. When a company goes public, the people selling their shares know a lot more about it than you do. It's akin to buying a used car, where the seller has intimate knowledge about the vehicle's infirmities while the buyer must decide after only a brief test drive and cursory inspection.
Fueling this situation is the fact that many companies going public nowadays were previously controlled by private equity firms. That matters, because the fundamental business model of such firms is to extract the value from a company before unloading its shares onto the public markets.
Caesars Entertainment (NASDAQ:CZR) is a textbook example. When the casino giant was taken public by its private equity handlers in 2012, it was laden down with $20 billion in debt. After subtracting intangible assets, Caesars was left with a tangible book value of negative $7 billion.
Fast-forward to today, and Caesars' interest payments have become unsustainable. In the first nine months of last year, servicing its debt consumed nearly half of the casino's total gambling revenues, leading to a $2.1 billion loss from continuing operations. Thus, it's no coincidence that Caesars is on the verge of putting its largest operating unit into bankruptcy as soon as this month.
Stacking the deck against individual investors
But even if the lemon problem wasn't an issue, individual investors would still be at a disadvantage when it comes to IPOs: Investment banks, which shepherd companies through the process, have a vested interest in maximizing the price of a company's newly issued shares, regardless of value.
Taking companies public is a lucrative and competitive business on Wall Street. And while investment banks wouldn't admit to it, one way they compete against each other for that business is by proffering the services of their research analysts -- that is, the people who are tasked with educating investors about the value of publicly traded companies.
A recent enforcement action by the Financial Industry Regulatory Authority gave a rare insight into that process for investors. At the beginning of last month, FINRA fined 10 banks between $2.5 million and $5 million each for "allowing their equity research analysts to solicit investment banking business and for offering favorable research coverage in connection with the 2010 planned initial public offering of Toys "R" Us".
In effect, the investment banks told Toys "R" Us and its private-equity owners that, if awarded the business, their research analysts would publish favorable reports about the retailer's value to sway investors and, by doing so, potentially inflate its stock price. It was the same thing many of the same firms did around the turn of the century, when their analysts pumped degenerate Internet stocks such as Pets.com and Webvan.com.
The net result is that it's difficult for an individual investor to get an objective assessment of the value of a newly listed company. And it's for this reason that investing in them calls for, in Graham's words, a "special degree of sales resistance."
The unfavorable timing of IPOs
Finally, I would be remiss if I didn't at least touch on the issue of timing. It's common sense that companies prefer to go public when stock valuations are high, as opposed to when they're low. By doing so, the sellers are more likely to get a price that's favorable to them and, concomitantly, less favorable to individual investors.
The data bears out that reality. In the lofty market of 2005 to 2007, an average of 200 companies went public each year. The number fell to only 31 after stocks plunged in 2008. Since then, the annual IPO volume has steadily increased with the market, topping out for the moment in 2014 as stocks soared to unprecedented heights.
In sum, when you add timing to the lemon problem as well as the conflict-of-interest issue that leads investment banks to inflate the value of newly issued stocks, it should be obvious that investing in this area is, to put it mildly, fraught with peril for the individual investor.
Getting back to Shake Shack
Of course, none of this guarantees that Shake Shack's IPO will yield substandard returns for the early investor -- relative to the broader market, that is. I've read more than one compelling analysis of its prospects. It's a great business. It's run by a restaurateur with impeccable credentials. Customers love it. And all of these things come through in the burger joint's growth trajectory.
But at the end of the day, prospective early investors in Shake Shack would be smart to go into it with their eyes wide open. While it could be, and hopefully is, an outright bonanza for anyone who buys in, such an outcome would be in spite of the IPO process and not because of it.
John Maxfield has no position in any stocks mentioned. The Motley Fool recommends GoPro. The Motley Fool is short Caesars Entertainment. 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.