When a Company Like Facebook Goes Public

Events of worldwide significance, including the Greek debt crisis and plunging oil prices, couldn’t compete with Facebook’s initial public offering for investors’ attention on the popular social networking service that launched in February 2004. There were highs and lows, as the stock rose to $45 a share and retreated to around $25. As of this writing, the stock trades around $32, off from its $38 IPO price.

Ronald Parker of Baltimore set his eyes on Facebook before the first day of trading. Using his Fidelity Investments brokerage account, he purchased 300 shares at $42 each, and another 200 shares at $36. Parker concedes that most small individual investors are shut out of buying hot issues because brokerage firms allocate IPO shares to institutions and other prime customers.

While most investors focus long term–and rightly so–investing in stocks and mutual funds through their 401(k) plans, Parker says some dividend-seeking investors look for stocks that are going to pay them 3% to 5%. Then there are traders like himself who identify high-growth companies such as Google and Facebook that move up and down in price.

Parker has since sold 200 shares of Facebook, buying and selling some put options once its stock price fell to $27 a share. In simple terms, there are two kinds of contracts options: “calls” let an investor buy a certain stock at a  price and “puts” let an investor sell it at a certain  price. Calls are generally used by investors who want to profit from a rise in stock prices, but avoid sharp losses. A put is used by investors seeking to profit from a fall in stock prices by selling the stock at a higher price quoted in the put before its expiration date.

Parker still owns 300 shares of Facebook. He wants to wait it out. “Most high-tech stocks would be making a lot of money if it weren’t for the economy and European debt crisis. But I still believe that tech is going to be a main driver,” he says.

Does the Facebook price saga indicate that individual investors should shy away from IPOs? Not necessarily. “For the most part, IPOs are usually underpriced. They tend to perform well in the first year of public trading,” says Shawn D. Baldwin, chairman and CEO of Capital Management Group, a boutique investment bank and research advisory firm in Chicago. Baldwin’s firm has participated in more than $68 billion in underwritings, including success stories such as Google, in which CMG was a co-manager. Baldwin says sometimes it’s better for individual investors to wait a while and see how the stock does after its IPO to find a good buying opportunity. “Look hard at the company and its industry before you invest.”

Indeed, companies that are now household names–Microsoft, Google, Intel, Walmart, Home Depot, Disney, Dell, Coca-Cola, Target, Starbucks, etc.–were once IPOs. If you had invested in any of these, you may have had some volatile price fluctuations along the way, but over the years you would have made enough money to substantially change the quality of your life.

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A single share of Johnson & Johnson purchased for $37.50 at the IPO in 1944, after stock splits and reinvested dividends, would be worth more than $1 million today. Similarly, a $5,000 investment in Walmart’s IPO for $16.50 per share in October 1970  would be worth more than $60 million. Clearly, a well-chosen IPO investment can be a financial boost if you make sound choices and hold on to them. On the other hand, companies such as WebVan, the bankrupt Web grocer, and Pets.com have left investors with large losses.

So how do you increase your chances of finding a Google instead of a Webvan? “Do the work,” says Carla Harris, a managing director with Morgan Stanley in New York. “You can do it yourself or trust that your financial adviser has done it carefully.”

The work, in this case, is looking into an IPO company’s background and evaluating its future prospects. “Read the IPO prospectus and other offering materials,” says Harris, who has executed such transactions as IPOs for UPS and Martha Stewart Living Omnimedia. “Look at the trajectory of sales, earnings, and read the risk factors that are listed and evaluate them.” As a result of your research, you should be able to make a cogent argument for investing. “You should be able to explain why you think the company will perform well,” she adds.

Besides checking on the outlook for individual IPOs, you may be able to use broad market trends as a guideline for investing. “Our data show that IPOs historically outperform the broad stock market, coming out of periods of low issuance,” says Kathleen Shelton Smith, a principal at Renaissance Capital, an IPO investment advisory firm in Greenwich, Connecticut, and a leading source for IPO research and analysis. After the August 2008—February 2009 and the August 2011—September 2011 stock market downturns, during which IPO issuance dried up, IPO stocks outperformed the major market indexes. The average return on all IPOs priced in the first half of 2012 was 20.8%, says Shelton Smith. Only the strongest, most attractively valued IPOs are able to come to market in such environments, and those stocks generally do well once trading begins.

“We are now in a period of minimal IPO issuance,” says Shelton Smith, “and I’m not sure how long it will last.” For any investors still eyeing Facebook, she suggests to first wait for confidence to return to the broader equity markets. Second, look for Facebook to apparently find a bottom; that is, the stock will stop dropping. With a class action filed against Facebook for not disclosing  information about its IPO to the public, “investors should factor in the

negative consequences of management distraction, legal costs, possible dollar settlements, and reputational risks of these pending lawsuits,” she adds. “Also, new IPOs will start up again,” says Shelton Smith. “These new IPOs probably will be priced attractively at that point because most investors will not have forgotten the Facebook disaster.”

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Looking ahead, the company has a sound business proposition, which should be evident in the revenue numbers that come out. “I also expect Facebook’s stock to get a pop when the company goes over 1 billion individual users,” says Baldwin.

Moreover, Baldwin notes that Facebook is so large and so widely followed a company that its stock will be included in major stock market indexes. “That means many index funds and ETFs will buy the stock, increasing demand and driving up the share price,” he says. “Those funds will hold on, too, so selling pressure may be reduced.”

Facebook is a top holding of Renaissance Capital’s Global IPO Plus Aftermarket Fund (IPOSX). For $5,000 ($2,500 for IRAs), individuals can invest in the mutual fund’s diversified portfolio of newly public companies that meet a strict investment criteria of the portfolio management team at Renaissance Capital. Notes Shelton Smith, history has shown that some of the greatest stock advances of all time occurred when companies were early in their development of groundbreaking products and services that eventually transformed industries and changed people’s lives.