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Investing in Facebook: An IPO for Fools

Investing in the Facebook IPO may not get you the returns you are looking for in the long run

Alanna Petroff 2 February, 2012 | 5:22PM

After years of speculation, the social networking site Facebook has announced its intention to go public. Without a doubt, this is the most highly anticipated initial public offering (IPO) in the technology sector since Google went public in 2004. But now comes the question: should you invest? According to extensive academic research, investing in IPOs is not necessarily a good idea.

Tarun Ramadorai, a professor at the Saïd Business School at the University of Oxford, has studied IPO data extensively. According to these studies, having a buy-and-hold mentality with IPOs is inefficient. It is much better to buy the shares initially and then dump them after a few months, or buy shares in their competitors, he says.

The data shows that shares in newly-IPO'ed companies tend to rally in the first day of trading, and then over 6 to twelve months, the company's shares perform well relative to similar companies, says Ramadorai. But, on average, the evidence shows that comparable companies will outperform IPO'ed companies by a substantial margin over the long run, he says.

“If you constructed a portfolio of companies with similar characteristics, then IPOs have been shown to underperform this portfolio,” he says.

For example, buying a portfolio of other large tech companies such a Google (GOOG) and Apple (AAPL) would, in general, be a better long-term investment idea than buying and holding onto shares in Facebook.

That is not to say that IPO'ed companies perform poorly; they simply do not perform as well as their peers.

Professor Jay Ritter at the University of Florida has collected data on 8,670 U.S. companies that had IPOs between 1970 until 2009. This is what the data shows, on average:

- In the first 6 months after the IPO, the company's shares will rise by 6.2% while shares in other companies in a similar sector with a similar financial structure will rise by 4%.

- In the next six month period, the IPO'ed company's shares will rise by 0.6%, while shares in similar companies will rise by 4.8%.

- In the second year of trading, the IPO'ed company's shares will rise by 7.1%, while shares in similar companies will rise by 12.7%.

Ramadorai says there are two main theories about why these companies underperform their peers. The first theory is based on the idea that when the management of a private company want to issue equity and go public, they will only go to the market when the company’s valuation is reaching a peak in order to get the best deal for themselves. “That means there’s a valuation trough coming up because you can’t get any higher than the peak,” says Ramadorai. The second theory revolves around the idea that investors overreact to IPOs. Investors generally become excited and bid the shares above a sensible valuation. Then when emotions cool off, investors realise the company has become overvalued and the shares will drop.

So how can you take advantage of this trend? “I’d try to get my hands on the IPO to begin with and then sell it after 6 months,” says Ramadorai.

If you are looking at investing in the technology sector, the Morningstar Fund Quickrank will help you find information about sector-specific funds.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

About Author Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.