The upcoming initial public offering for Twitter prompts me to wonder if this is something that would be a good investment bet. I don't "tweet" myself because I'm too verbose for a message limited to just 140 characters, but at last count there were millions of other people who were using the site so they don't need me at this point.
The issue of whether or not an initial public offering is a good deal for investors is debatable. A friend of mine who has participated in many startups over the years before they went public was, for example, in Google (GOOG) at $4 a share. He said that by the time a firm "goes public" the big money has already been made.
This would be confirmed by the rule of thumb that says a company's entire value is suddenly multiplied by a factor of four the day it goes public. In other words, the share price chosen for the portion of the company that will be sold to the public will establish the value of all the outstanding shares at the same price -- including those of people who received shares back when the company was struggling to get off the ground. Once it becomes a public company with shares traded from second to second on a major exchange, all outstanding shares, including those bought privately in the early stages, are valued at whatever price a single share trades at on the exchange.
The term for this mechanism is called "marked-to-market" and it is the key to the financial alchemy that creates billionaires overnight.
While folks here in the Bay Area get "all a-Twitter" about IPOs -- starting with Apple (AAPL) years ago and more recently with Facebook -- the facts are more sobering. The average IPO over one-, three- and five-year periods does not outperform just a small-cap index fund. And any single IPO carries significantly more risk.
For a look at results, check out Renaissance Capital, which offers IPO index funds of varying types (U.S., global, etc.). The three-year average annual result for the IPO index is 7.8 percent. For Vanguard's small cap index, the average annual three-year return is 21.29 percent. The five-year average annual return differential is also a disappointment for IPO fans -- 4.6 percent for the IPO fund and 9.8 percent for the small cap index.
I don't even want to think about how much more volatility and risk would reside in the performance of a single newly issued stock compared to an index of IPOs.
So why bother? As soon as they can, early investors who were in the stock back when it was private are typically foaming at the mouth to dump some of their shares as soon as they are beyond the waiting period.
People who subject themselves to more risk, in the aggregate, can expect to make more money in the long term. Small public companies, as a whole, tend to beat broad market averages by 2 full percentage points over longer periods (12 percent per year versus 10 percent). By comparison, anyone who feels like investing in an IPO in hopes of making a killing would be advised to go lie on a beach until the feeling goes away.
If you think the company really is promising, wait until the dust settles and invest later when the outcome is beyond the irrational exuberance stage. Take a look at Facebook, for example, which is now getting somewhere after two years of enduring a pummeled stock price. Or, for that matter, look at Tesla, which was flat for three years until it actually produced a popular breakthrough car.
As for Twitter, the story of its founding was told in the New York Times magazine last Sunday. The original founder who came up with the name "Twitter" (a sound used by birds to communicate) left the company early in its history and will not become one of the billionaires or hundred-millionaires created by the IPO. All that money sloshing around brings out the best in people, but more often, the worst in people. If you're tempted to invest in the initial offering, do it for the right reasons -- that you're in for the long term because you admire what the company does and that you have no illusions of making a quick buck.