More, smaller IPOs do not signal a bubble

About a year ago, we published an article expressing our concern that the landscape for companies making it from start-up to IPO had become very unhealthy and had turned into an absolute desert (see "Crossing the chasm to IPO becomes even more difficult," May 17, 2013).  

In that article, we noted that since 1999, and especially since 2008-2009, IPO data has shown a clear trend towards fewer and larger IPOs, making a distinction between the number of IPOs and the amount of dollars raised in those IPOs: the data at that time showed that even when the amounts raised turned back upwards, the number of IPOs remained depressed, indicating that only a few "super-investments" were making it all the way across the difficult chasm from startup to IPO, and that the few who did make it were going public for much larger valuations than were typical in the past (companies like Facebook typified this recent trend).*

We argued that this situation was a negative sign for the economy, for a number of reasons.  First, it indicates that many companies which might have been good enough to go public in the past were languishing in the desert between initial venture backing and IPO, where many would likely perish for lack of funds that in the past could have helped them get their companies off the ground.  When that happens, new and innovative ideas that could make the world better are never realized.  Competition that could bring down prices for consumers or increase quality in that particular industry dies before it makes it out of the nest.  Big incumbents can swoop in and buy up potential competitors for lower prices, either incorporating their potential competitor's innovation, or shelving it indefinitely.  Companies that could contribute to the general standard of living and to the economy might never provide the products, services, or jobs that they might otherwise have provided.

A second negative aspect of the unhealthy IPO desert of the post-2008 era, in our view, is the fact that the trend towards fewer and larger IPOs means that what we might call "ordinary investors" miss out on the opportunity to invest in young, innovative companies before they become behemoths.  If the only companies who make it to the IPO stage are marquee-names like Facebook (which went public at a valuation of over a hundred billion US dollars), then those companies are already huge, mature corporations when they make it to IPO -- and the IPO is by definition the first time that the general public has a crack at investing in those names.

Since we published that article last year, however, the situation has begun to turn around.  An examination of the IPO statistics over at the excellent website of Renaissance Capital now shows clearly that the number of IPOs is growing much faster than the proceeds raised over the past year.  For data through the 26th of March, 2014, their website shows that the volume of proceeds raised in IPOs in the US has grown by 32.2% versus the prior year at this time ("blue chart," below), while the volume of pricings of individual IPOs themselves has grown by an astonishing 83.3% for the same period!  This means that the trend is reversing: more and smaller IPOs are coming to the market.

Right on cue, however, the financial media is now wailing about an "IPO bubble."  Here is a sampling of some recent headlines:
That last article features this quotation: "One of the great indicators of a bubble is when young companies are trying to access the capital markets in great quantities.  We've seen a proliferation of these at an accelerating rate over the past six months."

We would disagree with that broad assertion -- in fact, we would argue that one of the great indicators of a healthy economy is when there are large numbers of young companies making their way "across the chasm" from start-up to IPO.  That is exactly what is supposed to happen in a growing economy!  

It is certainly possible for that process to get out of hand, and most would argue (ourselves included) that the process did get out of hand in the late 1990s, but we believe that it is very difficult to argue that the current environment resembles the 1990s in any way.  In fact, as the above discussion illustrates, the numbers argue that we have been in a very unusual IPO "desert" in recent years, and so arguments that a pickup in IPOs from smaller, younger companies after such a dearth should hardly be taken as a sign of an unhealthy "bubble" situation in the IPO market.

Pictured above is the first page of the initial offering prospectus from another "young company" that was "trying to access the capital markets" -- back in December of 1980.  That company was Apple Computer, and as the prospectus shows, they offered four million six hundred thousand shares of their company in their IPO, at a price of $22 per share, for a total raise (price to the public) of $101.2 million.*   If you take a look at the original prospectus here, you will find a table on page three showing that the company had a little over 54.2 million total shares outstanding at the offering, giving the company a valuation (or market capitalization) of about $1.19 billion at $22 per share.  In other words, the company went public at a much lower valuation than some of the mega-IPOs of recent years.  This meant that even "oridinary investors" could get in on this young company and experience growth in the years to come.  The company was by no means a behemoth by the time it came public.

Another illustrative example is Microsoft, which went public in March of 1986.*  As the first page of their prospectus (shown below) explains, Microsoft offered a total of 2,795,000 shares priced at $21 per share on the day of their IPO, for a total raise of $58.7 million.  If you take a look at their original prospectus here, you will find a table on page four showing that the company had a little over 24.7 million total shares outstanding at the offering, giving the company a valuation (or market capitalization) of about $519 million at the $21 per share.  

Again, we can see that the company went public early enough in its history that "ordinary investors" could purchase shares and participate in years of growth.  When the situation is skewed towards only behemoths like Facebook hitting the IPO market, the only people who can buy shares when the company is valued at $500 million (like Microsoft at their IPO) or even $1 billion (like Apple at their IPO) are the venture capitalists, angel investors, and corporate insiders at the company itself.

Some pundits are apparently happier to see the IPO market restricted to only the enormous mega-successful names, along the lines of Facebook, rather than Apple in its 1980 incarnation or Microsoft in 1986.  We believe that is a mistake, and that the current trend is a healthier sign.  We hope that it continues.

* At the time of publication, the principals of Taylor Frigon Capital Management did not own securities issued by Facebook (FB) or Microsoft (MSFT).  At the time of publication, the principals of Taylor Frigon Capital Management did own securities issued by Apple (AAPL).

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A walk down memory lane

Yesterday marked the five-year anniversary of the lowest point for the bear market of 2008-2009.  On March 09, 2009, the Dow Jones Industrial Average reached a low of 6,516.90 (today, March 10, 2014, the Dow opened the day at 16,453.10).  The S&P 500 index actually reached its low of 666.79 on March 06, 2009 (today, the S&P opened the day at 1,877.86).

On March 02, 2009, we published a post in this blog entitled "Don't get off the train," in which we wrote: 
As unbelievable as it seems now, there will be a turn in what seems to be a never-ending bear market cycle.  When the markets will turn back up is anybody's guess.  However, when it moves, it can move very rapidly.  [. . .]  This is why we have always emphasized focusing on the business and not the market prices, as we discussed in this previous post, as difficult as it might be in this environment.
One month later, we reflected on that discussion in a post entitled "Don't get off the train, revisited," in which we noted that there were plenty of people who had missed the sudden turnaround in the equity markets which took place in March of 2009 -- and that there were still plenty of people saying the move was just a "sucker's rally" (and we linked to an interview of one well-known investment personality saying that the recent rally was not to be trusted, that the March 9 bottom was not the bottom, and that "we're going to see more bottoms in the next few years").

Since that (incorrect) prediction by that colorful commentator, there has been no shortage of pundits warning that the recovery in the economy and the equity markets was doomed to collapse at any moment, and that investors were in for (as another confident financial personality put it) either a "nasty correction or years of treading water."  You can see on the S&P chart above where the markets were when we commented on that dire prediction -- and you can see where the equity markets have gone since that prediction and the returns that those who listened to those market predictions would have missed, had they taken that (incorrect) prediction to heart and stepped "off the train" based on what the pundits were saying.

During just about every dip in the chart above, there were serious-looking commentators standing by to deliver confident-sounding predictions of another "double-dip" recession, meltdown, or return to the 2009 lows.  Some of the posts we wrote in order to try to inform our readers of what they should really be paying attention to are listed along with an arrow pointing to the point in time at which we published them.  Those include "Double-dip ahead?" "More data says 'no recession.' So why is everyone so uneasy?" "Who is right, Bill Gross or Jeremy Siegel?  Answer: George Gilder"  and "Rip Van Winkle, revisited."

The point of this walk down memory lane is emphatically not to try to establish our ability to predict the market direction better than the talking heads you see on the financial media outlets.  We have always disavowed any ability to "call the market" correctly, year-in and year-out for decades -- and we don't believe anyone else can do that, either.

Instead, we believe that the lesson investors should take from the above record is that they should give up on the "persistent delusion" of trying to time markets, which (as the above chart shows) can be just as dangerous as trying to time trains!  We even wrote a post making that exact point, along with a graphic video that should drive it home quite strongly, entitled "Market-timing and train-timing," in which we said: "trying to time markets is a lot like trying to time trains: if you make a mistake, you can get flattened."

Today, on the fifth anniversary of the turn in the bear market, it should come as no surprise to find plenty of articles noting the occasion and ringing alarm bells that the "party could soon be over." We hope that readers of this blog will quickly recognize that the authors of those articles are reinforcing that "persistent delusion" -- and will waste little time with such "stock market guessing."  

We believe that time invested in finding well-run businesses positioned in front of fertile fields for future growth is a much better use of investors' time than listening to the prognosticators who can always find a host of reasons to back up their often-incorrect predictions (you can see the performance of the TFCM Core Growth Strategy here for an example of how our portfolio of well-run businesses has performed since inception).

We might even add that reading back issues of the Taylor Frigon Advisor might be a better use of their time as well!

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