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Lessons From Facebook's IPO

The social network's bumpy first week highlights the dangers of investing in buzz.

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Facebook's (FB) debut on the public market last Friday didn't do much to quell the heated chatter about the IPO. The only big change was that the tone switched from being distinctly positive to distinctly negative. Instead of hearing about the firm's breathless growth, we instead got plenty of reports on the myriad ways that the offering was allegedly mishandled. Investors that jumped in early were likely shaking their hands and licking their wounds, but even those who stayed on the sidelines can learn plenty from the hubbub.

IPOs Can Be Treacherous
Investors had several complaints about the Facebook offering this week. The first was mostly technical. It now seems clear that Nasdaq's (NDAQ) systems were not up to snuff for the huge volume of trades that poured through the exchange. The initial trading went so poorly, there were even rumors this week that Facebook was considering switching its listing to the New York Stock Exchange (NYX).

And although the mechanics of trading are important to all investors (remember 2010's Flash Crash), most people were more troubled by the news of how revised projections for Facebook's growth were disseminated. It emerged this week that Morgan Stanley (MS) and Goldman Sachs (GS) revised down projections for Facebook's growth ahead of the IPO, but they told only a small group of clients about it.

There is no sign that the banks did anything illegal, but it does underscore just how big the information asymmetry is for most IPOs. Small investors don't have much to go on before diving into an offering. They get a few SEC fillings and a few years of historical results. Compare this to the banks and their top clients, who have access to senior management and a much deeper knowledge of the business.

And the banks also have a vested interest in stoking the hype and talks of lofty growth levels. Their client is Facebook, not investors. Bankers are trying to maximize the amount of money that Facebook raises and to boost the returns of early shareholders cashing out. So the fact that they weren't exactly trumpeting the downwardly revised numbers shouldn't come as a huge shock.

Luckily, this informational advantage fades as a company spends more time on the public markets. Investors of all stripes get to see many more quarters of financial performance and can listen to management conference calls, and more analysts have an opportunity to weigh in on the stock. As a result, the direction of the business can become clearer. But trying to get in on an IPO that first day is more of a leap of faith than buying an established company's stock.

Buzz Doesn't Equal Profit
The Facebook offering also pointed to the dangers of chasing hype. Talk about the future of Facebook was on the lips of not just growth fund managers, but plenty of smaller investors who wanted to get in on the action.

The buzz for Facebook was deafening; a service that touches 500 million people daily has a tendency to do that. But just because something makes great cocktail party conversation, doesn't mean it makes sense as an investment at any price. Facebook may have a great future ahead of it (and signs look like it does), but if you don't buy the stock when it is trading for a fraction of its value, it can be hard to profit from that growth. If the stock is priced to perfection, it will likely tumble at the first stumble.

If anything, the buzz itself is a good sign that a stock might be frothy. We've seen time and time again investors chasing hot sectors and hot stocks only to be burned as the buzz moves elsewhere. It takes only a cursory glance at Morningstar's investor return data to see how investors have a knack for picking investments at the wrong time.

In Facebook's case, it seems that plenty of investors piled on not because they liked the stock at $38, but because they thought there was a greater fool ready to buy it at $45. This is a dangerous game to play. If everyone is thinking that way, demand can drop in a hurry, and shares can fall, as we've seen since Facebook's debut. It's important to look beyond what is trendy to what is cheap.

Tech Is Not Bulletproof
One of the surprising trends that emerged post-financial crisis was the ascension of a new wave of Internet companies. Thanks to new cloud services from Amazon (AMZN) and others, and the rise of smartphones, this new breed of tech firm could get off the ground without needing much capital, which was in very short supply during the crisis. Given that these were basically the only new firms on the block, and also given the huge growth numbers they posted, excitement over them grew very quickly. Private market valuations shot through the roof, and investors anxiously waited to get their hands on the first IPOs.

But now that investors have gotten a closer look at these firms, they seem to be less excited about their prospects. Take a quick look at the post-first trade performance at Groupon (GRPN) (-54%), Zynga (ZNGA) (-28%), and Pandora (P) (-33%) to see how fast sentiment has moved away from some of these names. ( LinkedIn (LNKD), with its easy-to-understand monetization model, is a notable exception). Facebook could be another addition to stocks that have wilted, at least in the short term, in the public markets, as investors closely weighed the growth prospects against the price.

It's not that Facebook isn't a great company; we give it a wide moat and think it deserves a lofty valuation--just not quite as lofty as the company hoped when it priced its IPO. This offering was just another example, albeit a high-profile one, that tech IPOs aren't special and that there is no reason to believe tech valuations have become unmoored from reality. Just like any other company, the fundamentals need to support the valuation, and in this case, they didn't justify a stock price well above $38. Perhaps this whole episode will finally debunk the myth that this new wave of firms are somehow immune to normal economics.

The vast majority of investors, particularly those with a long-term focus, let the Facebook IPO come and go without losing a dollar. But the entire episode provided a great lesson on the perils of following the hype.

Bearemy Glaser does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.