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Value Trap Alert: Avoid These Two Recent IPOs

Lurking in the shadows of the bull market, IPO activity has quietly gathered pace. The number of deals completed so far this year is up 43% over the same period in 2010.

But because it’s notoriously hard to secure shares in a hot IPO, the uptick has many investors hunting in the aftermarket bargain bin. They’re sifting through the list of recent IPOs for undervalued gems.

And they’re bound to land on two companies I mentioned yesterday – FXCM Inc. (NYSE: FXCM) and GAIN Capital (NYSE: GCAP).

Both went public last December. Both are trading below their respective IPO prices, at what appears to be attractive valuations. And both operate in a high-growth, high-margin industry.

Sounds compelling, doesn’t it?

But I wouldn’t be so quick to pounce on these “bargains.” Here’s why…

Check Your Moral Compass

As I noted yesterday, FOREX trading is the latest addiction for retail investors. They’re trading over $125 billion every single day and making an average of three trades per day.

There’s just one problem: They’re all losing their shirts in the process. Roughly 75% of all retail FOREX traders lose money.

And FXCM and GAIN Capital provide the opportunity for retail investors to perform so poorly. They operate two of the most recognizable FOREX websites around – DailyFX.com and Forex.com. Combined, they provide about 200,000 investors with FOREX trading accounts.

While there’s nothing illegal about their business models, there’s a certain slime factor associated with exploiting the ineptitude of FOREX investors in order to turn a profit – especially when it’s hardly a level playing field. (As I noted yesterday, Wall Street is investing millions to ramp up foreign currency trading teams, making it almost impossible for individuals to compete.)

Consider this: The average account size at GAIN Capital is about $3,000. And yet, it’s estimated that the company generates nearly the same amount in fees from the average account.

Investing in companies like that is akin to trying to make money from family and friends by getting them involved in a pyramid-marketing scheme.

I refuse to do it.

But even if you’re nonplussed by moral arguments, you can’t ignore the fundamental weaknesses of each business.

Consumers Are Wising Up… And Costs Are Rising

No matter how much you try to educate your customers, when 75% (or more) of them routinely lose money and only stay with you for a “relatively short” period of time, recruiting new ones becomes costly and problematic.

That’s the case here, with customer acquisition costs already increasing faster than sales for FXCM. In the last quarter, total revenue increased 29%, but advertising and marketing expenses rose 37%.

As time goes by and brokers constantly churn through customers, finding new customers will become even more costly. These higher costs promise to squeeze profit margins. And if share prices ultimately follow earnings, look out below.

That’s not all, either…

Regulatory Risk Could Erode Profits

It’s also important to note that both companies also face significant regulatory risk.

You see, each country imposes rules on how much leverage FOREX investors can use. It ranges from 20-to-1 to an unbelievable 200-to-1, but the trend is clearly for less leverage.

Take Japan, for instance, where the maximum allowable leverage dropped from 100-to-1 to 50-to-1 in August 2010. And it’s set to drop to 25-to-1 this August.

Keep in mind, FOREX attracts so many investors because you can wager a little to make a lot. It’s the same thing that draws people to Vegas. However, as regulators clamp down on the leverage ratios and, in turn, the profit potential, FOREX trading is bound to lose some of its appeal.

In addition, it’s only a matter of time before regulators turn their attention to the use of credit cards to open FOREX accounts. When they do, these companies could lose a meaningful chunk of their profits.

Over the past year, for example, 37% of new accounts opened at GAIN Capital were funded with a credit card. For FXCM, the number was about 20%.

Still not convinced to avoid (or sell short) these two stocks? Chew on this…

Take Your Cue From the Insiders

Insiders at GAIN Capital cashed out big time when the company went public. In fact, insiders accounted for the majority of the nine million shares sold in the IPO.

Hmm… if the long-term prospects were so good for the business, insiders should be have been buying (or at least holding onto shares), not falling over themselves to sell.

Bottom line: Although FXCM and GAIN Capital might trade at compelling forward price-to earnings ratios of 13.19 and 6.44, respectively, those numbers are based on estimates for future profits. And as the business fundamentals come to light, those estimates are destined for a downward revision.

Ahead of the tape,

Louis Basenese