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Money Talks

By Dr. Gregg Dimkoff
Professor, Grand Valley State University
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Several years ago, a recruiter for bank credit analysts told me he always asked job applicants this question: “Do you think someday in the future there will be no wars?” I was puzzled by the question until the recruiter explained that anyone who answered “yes” likely views the world through rose-colored glasses, falsely believing the best possible outcome always occurs. An applicant’s extreme optimism likely would interfere with the ability to identify and reject unqualified loan applicants.

That same type of optimism was apparent among many analysts who recommended buying shares in the new General Motors just prior to its IPO in mid-November. Those analysts might be right, and GM shares could soar in the next year or two. I certainly hope so, but there is a good chance they were looking at the IPO with the same rose-colored glasses the bank recruiter was trying to avoid.

Once again, the level of optimism about upcoming IPOs is heating up. Sometime this year Chrysler will go public with its own common stock issue. It’s also likely Twitter, Facebook, LinkedIn, Skype and Groupon (its business is getting retailers and restaurants to offer discount coupons to a pre-determined number of customers) also will have IPOs. Before you get excited about the possibility of making a killing in these stocks, you should understand how the IPO deck is stacked against individual investors. In fact, as a general rule investors should avoid IPOs.

To see why that is true, put yourself in the position of a large, privately held corporation’s CEO who has decided to issue shares to the public. You could time the IPO to occur in a few months, next year, two years from now — in short, anytime you want. What’s the best timing? Logically, you would time the IPO to immediately follow the calendar quarter with the highest earnings. You might even instruct your corporate accountants to manipulate expenses and revenues — within the limits of generally accepted accounting principles, of course — to goose earnings even further.

The best time to do an IPO is when the corporation’s performance is the rosiest. The IPO’s stock price will fetch the highest price, maximizing the funds the corporation receives. Do companies actually do this? Many do, some don’t. How will you be able to tell which is which? You can’t, and that’s a major problem with buying IPO shares. If a corporation paints an exaggerated picture of its prospects, its stock price is bound to dive if the company fails to meet the rosy expectations.

Yes, some rapidly growing companies continue to do even better after their IPOs. Think no further than Google and MasterCard, two companies whose stock prices soared in the months following their IPOs. If that’s the case, the smart money — mutual fund managers and managers of other financial institutions — will snatch up all the offered shares, leaving none for individual investors. If IPO shares make it all the way down the issuing pipeline to individuals, however, it means the smart money has passed. In other words, generally only the loser IPOs become available to individuals.

What about GM’s IPO? Shares made their way to individual investors, but GM’s IPO wasn’t normal. The company was under enormous pressure to repay the nearly $55 billion in federal government aid it received. Thus, it broke an IPO rule: Time the IPO to follow peak earnings. Instead, it timed the IPO to repay the federal government, to minimize taxpayer griping about favoritism (such as letting Lehman Brothers fail but rescuing GM), and to send a signal to the public that GM is back.

The biggest question about GM’s IPO is whether GM’s stock price will rise, making it one of the few successful IPOs for all investors. There are reasons to think this might happen. GM cut its expenses by billions of dollars during its fight for survival. It got rid of its unprofitable divisions. And there is no doubt auto industry sales now are far above the breakeven point.

On the other hand, GM faces several major challenges. It must demonstrate its 2010 earnings weren’t a fluke, and weren’t the result of financial and accounting manipulations. A corporation cannot continue to create earnings out of nothing. Sooner or later, earnings will reflect the true state of affairs. After GM reports two or three more quarters of earnings, we’ll have a clear idea about the true value of GM stock.

If the trend of increasing earnings continues, many individual investors in Michigan will let out a sigh of relief. In the meantime, the safe thing to do is to take a pass on all the big-name IPOs you’ll hear about in 2011.

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