It took electric carmaker Tesla Motors (Nasdaq: TSLA) six months after its initial public offering (IPO) to succumb to the “winner’s curse.”
Shares of General Motors (NYSE: GM) gave way in three months.
But freshly minted public company, Zipcar Inc. (Nasdaq: ZIP), promises to fall victim even faster.
What is this curse – and how can you avoid falling for it, too? Let me explain…
When Winning Actually Means Losing
The concept of the winner’s curse comes from the auction world. It represents the tendency of winning bidders to overpay for items.
For example, let’s say I want to auction off a jar of coins. If people bid honestly, they’re going to guess the value of the coins and bid slightly less than that amount.
Studies show that the average bid among the group should come very close to the actual value. (This phenomenon is known as the wisdom of crowds.)
But that means the winning bidder is going to be someone who actually overestimates the value of the coins. So that person wins the auction, but loses money because they paid more than the market value. Hence, the winner’s curse.
Investment Bankers Know We’re Easy Prey
The winner’s curse surfaces all the time on Wall Street with IPOs. After all, IPOs are nothing more than auctions. The item being auctioned is a private company. The investment banker is the auctioneer. And investors are the bidders.
And just like an auctioneer, the investment banker’s primary concern is to get the highest price for an item. They could care less about its actual market value, or whether or not investors stand to make a profit.
And the sad truth is, we’re easy prey. We’re easily duped into overpaying.
That’s because information on IPOs is notoriously scarce. The only source is typically the IPO prospectus, or S-1 filing. However, the average IPO prospectus checks in at 200 pages. So few investors ever take the time to review it.
Instead, investors are completely unprepared when they invest in new public companies. Rather than come armed with facts and figures, the hype surrounding a deal guides their bidding. And the more hype an IPO has, the more they overpay.
The problem is, IPO hype ultimately fades. And when it does, look out below!
Hope Floats, Hype Fades
A 2004 study on investor demand for IPOs and their aftermarket performance found that “IPOs with high investor demand have large positive initial returns but negative longer-run excess returns.”
Simply put, the hottest IPOs might enjoy an initial rally, but share prices ultimately head significantly lower to reflect the true market value. On average, overhyped IPOs are down by double digits within six months.
Recent history bears this out, too…
~ Tesla Motors: In June 2010, Tesla Motors debuted to significant fanfare. Shares were priced at $17 and raced 114% higher in about five months. Then investors realized they owned nothing more than an overpriced electric vehicle manufacturer with minimal sales and no chance to profit until 2014.
End result? Shares are down 25% from their peak – and trending lower still.
~ General Motors: In November 2010, General Motors relaunched on the stock market. Investors cheered, as it signified the unwinding of the government’s stake in the carmaker. The IPO was priced $4 higher than originally planned and shares raced 20% higher in three months. Then investors woke up to the company’s history of steep losses, indebtedness, lack of competitiveness in North American markets and a still sizeable 35% government stake.
End result? Shares are off 20% from their peak – and they’re trending lower, too.
That brings us to the hip, car-sharing company, Zipcar.
Less than two weeks ago, the company priced its IPO to $18 per share. And in no time, shares jumped 75% higher.
Such a dramatic price jump is ominous news. And as I’ll reveal tomorrow, there’s serious cause for concern.
Zipcar’s stock is now completely detached from its underlying business fundamentals and I’m convinced that the winner’s curse is going to strike again here, as well.
Not only that, it’s going to occur much quicker for Zipcar. Click here to find out exactly why.