Profit From Sophomore Slumps

It seems basketball analogies are everywhere these days, so here's one more to pass your way: the sophomore slump. It happens to players who come out of the gate strong but falter after time passes and expectations increase. Instead of jumping on the bandwagon (we were all George Mason fans last year, right?), The Fool advocates that you take a step back and do your homework when faced with a fiery freshman. Buying into a company destined for a slump can be a costly leap of faith.

History lesson
During the NCAA basketball tournament, there's usually a freshman who steps up his game and makes a big impact. Freshman phenom Pervis Ellison led Louisville to the NCAA title in 1986. Michael Jordan hit that jumper to beat Georgetown in the 1982 championship game. Freshman sensation Carmelo Anthony led Syracuse over Kansas for the 2003 title.

And last year, LSU had freshmen Tasmin Mitchell and Tyrus Thomas, both of whom helped propel the team to the Final Four.

Reality check
While Jordan went on to become a megasuperstar in the NBA, and Carmelo Anthony continues to make his mark in the pros, it doesn't always end well. (Just ask Pervis Ellison.) Unfortunately, some young players who could do no wrong in their first season will fall victim to the pressure. Cue the dreaded sophomore slump. Stats drop and play turns erratic -- or just plain ugly. But there's a lesson to be learned here: Slumps can be temporary, whether they're on the hardwood or in the market.

Professor Jay Ritter of the University of Florida concentrates much of his research on IPOs. In his paper, "The Long-Run Performance of Initial Public Offerings," he concludes that investor expectations tend to be too high when firms first become available to the market.

These overly optimistic expectations drive up prices in the short term and drive down returns over the long term. I particularly noticed Ritter's reference to a paper by Roger Ibbotson entitled "Price Performance of Common Stock New Issues." According to Ritter, Ibbotson's paper showed that relative to their IPO prices, newly public companies tended to have positive returns in the first year, negative returns in years two through four, and positive returns in year five.

So maybe the best time to invest is in the second year. Why? Because there's bound to be some sort of slip-up along the way as a part of the growing process, and the market doesn't like slip-ups. In addition, there is usually selling pressure from some group of early-stage investors looking to lock in their returns.

Real-world sophomore slumps
Here are several companies that saw their share prices decline following their market debuts.

Build-A-Bear, the make-and-dress-your-own-stuffed-animal company, missed earnings expectations last spring, which sent shares tumbling. Cabela's, the outdoor sporting goods retailer, has seen tough same-store-sales comparisons as new stores open with better-than-expected results. In addition, there's been insider selling at Cabela's and a secondary offering putting pressure on the share price. Finally, office furniture designer Knoll missed earnings estimates last fall.

From the table above, we see that because of these missteps, the market offered investors the chance to buy at lower prices. Again, expectations were running high after those three companies hit the scene. But when performance didn't meet expectations, share prices fell, creating buying opportunities.

It's worth your time
In my screen for post-IPO bargains, a few interesting names popped up.

(Please remember that these are ideas from a screen, and they haven't been thoroughly researched. They're meant to be a starting point, not an investing recommendation.)

Kinetic Concepts, the medical technology company specializing in wound-care and tissue-repair technologies, and Great Wolf Resorts, the waterpark-themed hotelier, both ended 2005 in a downturn. (Their troubles, as reported by the Fool, are documented here and here, respectively.)

Nalco Holding is a water-treatment technology company. According to my former colleague Stephen Simpson, Nalco is now the second-largest water-treatment technology company, behind General Electric (NYSE:GE). (See the full story here.) For Nalco, that's not a bad position to be in. Are these three companies poised for runs in 2007? I can't say for sure, but I do know that it's worth our time to investigate.

The Foolish bottom line
IPOs are fraught with enthusiasm, and enthusiasm drives up prices. While it's easy to get sucked into a good story, it's better to sit back, take your time, and learn about businesses that attract your interest. That way, you can find out for yourself how they create value, and perhaps you can get in at a better price. The Motley Fool Inside Value team wants to avoid owning stocks that could go into a sophomore slump. Instead, we choose to profit from the stocks we feel are on their way to stardom.