September 24, 2012
By Matarin Capital Management
No news was bigger in the second quarter than the initial public offering (IPO) of Facebook. At Matarin, we do not invest in recent IPOs given the low quantity and quality of available fundamental data. Warren Buffett once said, "It's almost a mathematical impossibility to imagine that out of the thousands of things for sale on a given day, the most attractively priced is the one being sold by a knowledgeable seller to a less knowledgeable buyer". As is often the case, we tend to agree with Mr. Buffett.
Just to remind our readers, Facebook was priced at $38.00 on May 18th and briefly traded in the low $40s during that day. By month end, the share price had declined to $29.60, and as of August 24th, Facebook was trading below $20.00 a share. While IPOs tend to get a lot of publicity on their opening day of trading (when they tend to do quite well), the Facebook IPO got us thinking about the longer-term performance of IPOs. So, using data sourced from FactSet and Compustat covering IPOs issued from 1997 to 2009, we structured a simple test looking at the performance of positive Free Cash Flow (FCF) generating IPOs, negative FCF IPOs, and all IPOs over the subsequent three-year period starting at month-end following the IPO. We used FCF because we believe it is a reasonable measure of whether a company has a good business, and we chose a three-year time period because it is a reasonable time horizon over which a long-term investor can judge the success of an investment, IPO or otherwise.
Mr. Buffett would be interested to know that what we found is consistent with his belief that investing in IPOs shortly after they are issued is not a profitable strategy. In fact, the pool of 1472 IPOs in our sample underperformed the small-cap market by an average of 6.0%. Interestingly, had you bought only the IPOs that generated positive FCF over the prior year, and held them for three years you would have outperformed the market by 23.0%. On the other hand, the negative FCF companies went on to underperform the market by 26.0%. This may be good news for long-term investors in Facebook, which is a positive FCF company. This is one piece of good news for Facebook investors. While Facebook does not currently look cheap (based on the limited data available), it does appear to have a viable business model throwing off significant FCF.
We are not invested in Facebook and are not recommending our readers invest, but we would not suggest avoiding it simply because it is an IPO.
Source: This article was originally published in "Matarin Capital's Study of IPOs Reveals Strong Performance Advantage for Positive Cash Flow Companies", www.matarin.com. For additional information about Matarin, please contact: Marta Cotton, Principal, Director of Client Development, firstname.lastname@example.org, (203) 998-0484.
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