It
will likely go down in history as one of the biggest flops the stock market
has ever seen – at least initially. The comedy of errors that have
resulted in the loss of billions of dollars of market capitalization and
shareholder value is noteworthy. The greed of many that led up to the flop
really needs to be dissected though. The purpose of this article, however, is
not merely to bash Facebook or anyone else, but rather to shine the light of
day on what are generally accepted business practices. Since Facebook has
become a household word in the past few weeks, it presents an outstanding
opportunity to connect the dots in the hopes of educating retail investors
and tipping the scales a bit in favor of the little guy; at least in the
information department.
Media
Hype – Justified or Unjust?
The
headlines alone in the days and weeks preceding the IPO would have had market
newcomers believing that Facebook was about to save the world, at least in
terms of its benefit to the financial markets. It was going to be the
offering that would bring retail investors off the sidelines and get them
active in the markets again. This was a classic pump and dump. The media got
people frothy and I took phone calls from numerous clients and interested
parties, many of whom said they felt that the stock would immediately go to
$150 or more a share just because everyone was talking about it.
It
truly reminded me of the dot com days when offerings would take off just
because the company had a fair amount of web traffic and had the letter
‘e’ in its name. Fundamentals were forgotten and money was put on
the line. Obviously we know how that ended. The best friend of underwriters
and insiders is a public whipped into a frenzy about
an IPO. It allows the insiders to cash out at above market equilibrium
prices, make a fortune, and as a result lose most of their incentive to
ensure the company’s success moving forward. We’ve seen it
hundreds of times already, yet this time it was going to be different. The
question must be asked then, who exactly does the financial
media work for anyway? If you need a roadmap to answer this question,
it is probably best to stop reading here because what follows will likely be
very upsetting.
The
media once again has shown its true colors and its inclination towards
sensationalism. At best this is a symptom of the 24-hour news cycle
we’ve become immersed in as a society and the competition for ratings.
At worst, it is another piece of evidence that builds a very convincing prima
facie case that the media is nothing more than extension of the financial
establishment, used once again to the betterment of the establishment at a
great cost to retail investors.
Imperfect
Information – Are Markets Really Efficient?
One
of the things often recited much in the way a sacred creed would be is the
idea of something called the Efficient Market Theory, aka Efficient Market
Hypothesis (EMT). This is the idea that the marketplace is always efficient.
This efficiency is based on five major criteria, one of which is the construct
of perfect information. The assumption in EMT is that all financial and
economic agents have equal information. With the advent of the Internet, one
might falsely assume that this is actually true. Sure we know a whole lot
more thanks to the Internet than we did before it, but is
the playing field equal? Not a chance. This IPO was another shining example
of that.
For
evidence I submit an article posted on CNBC’s website on Tuesday May
22, 2012. The article asserted that Morgan Stanley, the principal underwriter
(bank in charge of offering Facebook shares) released a note to ‘major
clients’ regarding the opinion of its consumer Internet analyst on the
Facebook offering.
“In
the run-up to Facebook's $16 billion IPO, Morgan Stanley, the lead
underwriter on the deal, unexpectedly delivered some negative news to major
clients: The bank's consumer Internet analyst, Scott Devitt,
was reducing his revenue forecasts for the company.The
sudden caution very close to the huge initial public offering, and while an
investor roadshow was underway, was a big shock to some, said two investors
who were advised of the revised forecast.
They
say it may have contributed to the weak performance of Facebook shares, which
sank on Monday — their second day of trading — to end 10 percent
below the IPO price. The $38 per share IPO price valued Facebook at $104
billion.”
We
could argue all day and into the next about Morgan Stanley’s obligation
towards all of its clients to release this very pertinent information. For
however large of a point that is, it pales in comparison to the idea of
perfect information in the marketplace. There is no such thing and this is
living, breathing proof. People who seek to refute the notion of EMT
generally point at insiders and the illegal distribution of information to
third parties as being the only thing that makes the playing field unequal.
However, the fact of the matter is that critical information is nearly always
reserved for ‘preferred’ clients over the masses. And as
you’ll find over the coming weeks and months, the bank will likely get
away with it from a legal perspective. However, as a retail investor,
understanding that you’re most likely not getting the
whole story is critical to protecting yourself against these types of
situations.
Morgan
Stanley may well end up getting itself sued by the balance of its clients
– everyday folks who trusted the firm to make wise decisions on their
behalf – but that is only half the story. Retail investors with no ties
to the underwriter were also negatively affected by this imbalance of
information. So much for the idea of market efficiency.
Epitome
of Greed
As
more and more information comes out about how this deal went down and the
decisions that were made, it should become very apparent to even the most casual
of observers that greed was the driving force throughout the entire process.
While this may not come as a shock to most folks, the rather transparent
nature of the greed in this case is definitely noteworthy.
Even
more important to understand is how the Facebook executives and underwriters
sacrificed their implied and express fiduciary responsibilities to those who
would become Facebook shareholders. Morgan Stanley is already being
‘investigated’ by FINRA and the SEC over its alleged warning of
certain large clients regarding the findings of its internal analyst just
prior to the IPO. The real problem here is that if we assume hypothetically
that Morgan Stanley is found to have acted improperly, nothing of substance
will be done. Sure, they’ll have to pay a fine and it may be several
hundred thousand dollars or more. They’ll sacrifice a middle manager or
low-level executive or two and will claim to have learned the lesson well and
will promise to reform. The sad thing is that this is tantamount to you and I
doing 120 in a 55 to complete a deal worth a few thousand dollars and
receiving a three-dollar speeding ticket. Morgan Stanley released the
following statement regarding the distribution of its analyst’s pre-IPO
change of heart:
“Morgan
Stanley followed the same procedures for the Facebook offering that it
follows for all IPOs. These procedures are in compliance with all applicable
regulations," the brokerage said in a statement to CNBC.
"After
Facebook released a revised S-1 filing on May 9 providing additional guidance
with respect to business trends, a copy of the amendment was forwarded to all
of MS’s institutional and retail investors and the amendment was widely
publicized in the press at the time.
In
response to the information about business trends, a significant number of
research analysts in the syndicate who were participating in investor
education reduced their earnings views to reflect their estimate of the
impact of the new information. These revised views were taken into account in
the pricing of the IPO.”
There
is just too much incentive in today’s financial
structure to cheat, lie, and obfuscate. The penalties don’t
serve as an effective deterrent and the practice goes on unabated. This is
certainly not an isolated incident. The only reason we’re even hearing
this much about it is because of the publicity surrounding the offering. And
this also plays into the idea of market efficiency’s major assumption
– that all actors and economic agents have access to the same information.
The
Fallacy of Retail Demand
The
real chicken dinner winner of the whole Facebook IPO was the idea of record
retail demand. The company marketed its offering feverishly and was certainly
successful in ginning up a lot of talk and speculation, but when it came down
to it, there were way too many shares offered. Showing a complete lack of
understanding of demand, Morgan Stanley went as far as to increase the number
of shares floated by 25% just before the offering commenced.
Even
in the first hours of trading, the financial press was almost giddy at what
was called ‘record retail demand’ as the shares went from $38 to
$45. That initial burst of buying was replaced almost immediately by fervent
selling and before the first session was over, underwriters had to step in
and support the offering by buying up shares. In short, there were too many
shares out there and not enough buyers. While there may have been
‘record demand’, there were way too many shares otherwise prices
wouldn’t have tanked. There were scads of reports of funds of all
stripes receiving double and even triple the allotment of shares they
requested. Their obvious first step was to trim their positions.
Exacerbating
the problem was the inability of Nasdaq OMX to
handle the flow of orders. Traders and investors were relegated to tracking
their positions on spreadsheets and legal pads for much of Friday while Nasdaq struggled to fix the problems. The delay in order
processing resulted in losses for many investors and at least one lawsuit has
already been filed with likely many more to follow.
Lack
of ‘Value’
Tying
into the fallacy of Morgan Stanley’s claim that the new information was
priced into the IPO is the reality that of the two potential ranges of price
offerings given pre-IPO, the final price was at the highest possible level of
the two ranges - $38/share. That created a Price/Forward Earnings multiple of
around 100, which is several orders of magnitude higher than that of
established tech stalwart Google (P/E around 23). For most investors, Google
was the only parallel example in recent memory as pertained to the scope and
hype of the offering.
It
doesn't take a Wall Street analyst to point out that Facebook, despite all of
its popularity among users and tentacles throughout the web, still derives
nearly all of its revenues from advertising. And that advertising is
contracting in 2012 and is expected to continue to do so in 2013. The hubris
of those involved in the decision-making process regarding the pricing of the
IPO is unequalled in recent memory. The thought process clearly at work here
was that people would be willing to pay an exorbitant premium just because it
would be cool to own Facebook. At least that is the distinct impression this
author got. Ironically, this time I’m not alone by any stretch as many
mainstream analysts and money managers shared that opinion as well.
Take
Home Lessons
The
simple lesson that can be learned from this whole experience (which is
nowhere near over yet by the way) is that in the end fundamentals will rule.
The past two weeks are very reminiscent of the hype surrounding the boatloads
of IPOs by various Internet companies in the late 1990s. This was to be the
biggest ever and so far it has gone down as a huge flop. Absent significant
propping by either large shareholders, the underwriters themselves or an
aggressive stock buyback program, it would seem that Facebook shares are
doomed to mediocrity; at least for now. A second lesson to learn is to never
underestimate hype and the greater fool principle that there will always be
someone willing to pay more than you did. After nearly a week out on the
tiles, many singed Facebook investors are learning what value investors have
known for a long time – occasionally, IPOs are nothing more than hot
air.
Until Next Time,
Andrew W. Sutton, MBA
Chief Market Strategist
Sutton &
Associates, LLC
Interested in what is going on in the markets and
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