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Monday, September 10, 2012

IPOs and Shooting Stars...Not Healthy For Your Portfolio

Shooting Stars and Ipos

As an investment advisor there are two categories of stocks I most frequently get asked about. IPOs and shooting stars.
These categories share 2 things in common high visibility (everyone seems to be using their product), often it’s in the news and it seems like a “sure thing’  Potential investors also suffer from two well known characteristics now part of the textbook list of pitfalls of behavioral finance and in fact decision making in general. The brilliant and highly readable book on this subject is by Daniel Kahneman: Thinking Fast and Slow. Kahneman was the first and only winner of the Nobel prize in economics to come from Psychology and I think the first Nobel Prize winner in the field without a degree in economics (there have been other social scientists since). 
Kahneman’s work is important for learning about the sometimes irrational behavior of the markets when price differs from value. In other words markets can be irrational and cause bubbles and busts. But I think there is merit to the critique: no one has shown a systematic way to make money off behavioral finance.
But I think there is a way to avoid losing a lot of money through investing avoid IPOs and shooting stars. And avoid falling into the biases of paying attention to a selective sample of information which reinforces confirmation bias. You think the product is ubiquitous therefore it is a good investment and you know people that have made a lot of money IPOs picking hot stocks or buying the individual stock in question. In fact as a group IPOs and shooting stars are as a group the worst category of stocks.
IPOs (initial public offering).  This one may be more obvious due to the largest and most publicized IPO…facebook.  Nevertheless before the IPO many investors were salivating at the prospect (investment professionals(mutual and hedge fund managers) were included in the group. Relatively unusual this time was that some retail investors got access to the IPO …that in itself not a good omen.
Why were they interested in facebook ? Because they only remembered and/or remember about the big money made in some IPOs…and didn’t hear (especially at cocktail parties) of the larger percentage of duds.
What were they looking at something like Google (of course ignoring the jaw popping 50% drop.

But they failed to think about IPOs  such as Groupon

Therefore they looked at Facebook with optimism. As a wiseguy (not me of course) would say: how did that work out for you:

Shooting Stars: shooting stars are attractive for some of the same reasons: I see someone using all of the product, therefore it must be a successful company and a good stock. In addition since the stocks are already on the market.  The stocks also share:
They are usually small growth stocks (small companies with forecasted high growth) in general the worst category of stocks in the traditional market  cap (large/small) and growth/value division. Think of a quadrant dividing the market (small value large value large growth large value)
They trade at a very high (P/E) price earnings valuation (as well as other metrics) indicating high optimism of continued high growth.
Because stock prices have had tremendous gains they have heard from or read about some investors/traders making big money.
Often the stocks will become “short positions” for professional aggressive investors. Therefore if they were early and the numbers temporarily remained positive..they may wind up buying back the shares (short covering) and the stock will have a sharp move up.
The problem because the forecasted high growth is factored into the price  bad news about prospective growth falls and the stock price takes a big drop as the “shooting star” falls to earth.
Why is this: often the shooting star is related to a consumer (often fashion/fad) product that seems ubiquitous, is premium priced for it’s uniqueness. But it is usually a product that can easily be knocked of appear in a cheaper person in a mass market retail outlet (think Target). The number of people willing to pay the premium price drops as does the stock.
An example would be Deckers the importer of those UGG boots that seemed to be on the feet of every trendy young person. To put it bluntly when the popular shoes were available at Nordstrom  or the UGG stores at a premium price and the knockoffs at places like Target…there were only a limited number of people to buy the original. Despite the effort to broaden the brand the anticipate earnings…and stock price as dropped like a rock. 

Another would be Crocs

Two Shooting Stars That Earn a Yellow Light

Two stocks that fit the characteristics of shooting stars but have not(yet ?)  fallen to earth:

Lululemon: This is the seller of yoga pants and other hot products sold at their own stores at premium prices. Knockoffs that are priced at a far lower price are prominently displayed at Target and elsewhere. Is there a limit to the number that can be sold at the premium price. The market seemed to think so, although good news last week created a big (I think short covering) rally. The stock carries a P/E of 57.

Underarmour: the hot athletic wear premium priced product. It’s current p/e is an eye popping  128.

 As a point of comparison Nike trades at a P/E of 21 and sells products competing with both Lululemon and Underarmour

What is my answer to clients interested in buying IPOs and shooting stars: I make the points above and suggest if they want to buy them they open an account I don’t manage and purchase it there.

Interestingly a company/stock that doesn’t fit the characteristics of a shooting star is Apple. Apple does have a unique premium priced product but they are difficult (and given recent court rulings perhaps even more difficult) to copy.
Apple of course is the world’s largest company, it’s large cash position makes bankruptcy virtually impossible.  And interestingly relative to earnings it doesn’t seem expensive. the p/e is 16.  A new iphone is to be unveiled this week and a smaller cheaper Ipad is in the works. Is the stock worth buying on price dips  ? I’ll leave you to judge.

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