The Little-Known Secret to Profitably Trading IPOs
How low can Facebook’s (Nasdaq: FB) stock go?
While I can’t predict that with certainty, I can assure you this: The further shares of the social networking giant fall, the more the mainstream financial press is going to warn everyday investors about investing in IPOs.
Heck, they may tell you to avoid IPOs altogether. But I would never recommend the same. Here’s why…
A Millionaire’s Market
As author and financial commentator, David Menlow, once said:
“More millionaires have been made in the IPO market than any other segment of the stock market. In fact, you could even go so far as to say more billionaires have been made in IPOs than any other segment of the market.”
The common perception, however, is that those IPO riches are reserved for “insiders” – company executives, investment bankers, mutual fund managers, etc. And I’ll admit, Facebook’s IPO flop doesn’t exactly provide evidence to the contrary.
Following a disappointing earnings announcement last Thursday, in which revenue growth slowed again, shares are off roughly 45% from the IPO price. And the stock is plumbing new all-time lows with each passing day.
But therein lies the secret to profitably trading IPOs. It’s a simple one, too. And one I’ve shared with you before: An IPO is an investment in the future growth of a company.
With that in mind, we can easily predict the IPOs that are going to perform the worst in the aftermarket. They’re the ones with uncertain or dimming futures. Specifically, companies with decelerating growth – like Facebook. (Its future growth is so uncertain, management won’t even issue guidance.)
More importantly, it means we can also easily predict the IPOs that will perform the best in the aftermarket. They’re the ones with the brightest futures – companies with steady (and better yet, accelerating) double- or triple-digit growth rates.
IPO investing is really that simple.
In fact, I’ve used this secret to successfully predict the ultimate demise of Zynga’s (Nasdaq: ZNGA), Groupon’s (Nasdaq: GRPN) and Facebook’s IPOs. Not to mention the ultimate success of LinkedIn’s (NYSE: LNKD) IPO.
As you can see from this chart, the IPOs for Zynga, Groupon and Facebook crashed and burned, despite all the hype surrounding them. Meanwhile, LinkedIn – easily the least hyped IPO of the bunch – is actually up from its first day closing price.
Let me stress again that this performance disconnect is no accident. It’s a reaction to the growth rates for each company. If you have any doubts, take a look at this…
The table shows the year-over-year revenue growth rates for each company. You’ll notice growth is dramatically decelerating for Zynga, Groupon and Facebook. The slowdowns started before each company went public (warning sign #1) and continue today (warning sign #2).
In the far right column, you’ll see that the drop-offs are most evident when we look at the change in year-over-year growth rates since each company went public.
You’ll notice, however, that LinkedIn’s growth has remained stable and impressive, averaging above 100%. And go figure… As its growth rates held steady, so did its share price.
Bottom line: The secret to profitably trading IPOs boils down to ignoring the hype and, instead, focusing on growth. If it’s decelerating, steer clear. If it’s above average and accelerating, back up the truck and get ready to share in the IPO riches.
Ahead of the tape,