American IPOs are destroying everything that I know and love about IPOs. After continuous poor performances of Facebook, Zynga and Groupon IPOs, I have paid ZERO attention to the IPO market because it is more frequently used as a strategy for founders and investors to dump their shares rather than as a channel to raise capital. This phenomenon is now documented in many textbooks, “poor performing companies are eager to go public, while well performing companies want to keep profits to themselves”.
Chinese IPO in Shanghai and Shenzhen
If you grew up in China or are interested in the Chinese stock market, then you would know that an IPO is a massive thing there. Individual investors have the right to participate in IPOs in the form of a lottery. Winners of the lottery can secure a large one-day return in all cases that I have observed in the past 13 years.
IPOs stand out in the heavily regulated Chinese stock market. They defy rules of the exchange, and allow prices of stocks can go up or fall freely for the day (this rule has changed as of Dec. 2013). When I was a kid, I used to document the first day return of IPO companies and rank them for amusement. All of them generated massive returns.
Research shows that Chinese IPOs generate an average of 230.76% first day return (Closing/IPO-1)[1]. The unconventional massive first day return is the result of companies purposely leaving money on the table for institutional and independent investors, and this phenomenon challenges all IPO theories that scholars concluded from the US market.[2]
American IPOs
American IPOs are not nearly as exciting as Chinese ones because US companies want people to buy fair priced stocks (Yes, I am spoiled). Facebook, for instance, went to IPO with an overvalued of 120 P/E ratio. Google, on the other hand, took it one step further by adopting an auction IPO approach to eliminate excess demand.[3] This resulted in leaving all money in the pockets of investment bankers and companies’ balance sheets.
Chinese IPO defies American logic
Chinese IPOs in NYSE/NASDAQ react very differently compared to American IPOs, plus they maintain their root characteristics. IPOs of internet focused Chinese companies listed in the US generate an average of 44.7% first day return, well above what average American internet companies generate.[4]
Additionally, Chinese companies occupy 3 spots of top 5 IPOs with the highest first day return. [5]
The Chinese mentality
Although companies lose out on the value between IPO price and the closing price, Chinese companies have the tendency to leave money on the table because it is a form of branding. Additionally, the feeling of seeing your stock is trading well above the opening price can be very rewarding. It is also a morale boost for company employees (nobody wants to see their companies crash and burn on the first day of trading).
How can you apply this to Alibaba and your portfolio construction?
As a practical guy, I like to turn theories into wealth. From what I have observed, there is one thing you can do to make some profit.
a. Alibaba is undervalued, which is likely to be corrected by their IPO.
Alibaba has an initial expected valuation of $65 billion — $75 billion (determined by its offer price and issued shares), which seems very undervalued for a business that handles more than ¥1 trillion transactions, and owns top innovative businesses in China. You can bet that the market will begin to adjust to a higher valuation when the market opens. As a person who grew up with Alibaba, I am leaning towards a $150 billion — $175 billion valuation.
Alibaba, similar to other technology giants that IPOed in the US market, will experience a large first day return from market adjustments; therefore, the stock price will approach a more appropriate valuation. Since, we don’t know what price will Alibaba open at, there is no strategy at the moment to take advantage of the mispriced valuation through buying or selling Alibaba. However, there is still another way you can profit on the mispricing.
b. Buy Alibaba’s biggest shareholder — Yahoo
Buy Yahoo today! Yahoo is valued at $36.16 billion by the time I am writing this. With 24% equity in Alibaba, new management, talent recruitment and over $1.5 billion EBITDA from core businesses, the company seems very undervalued.
Additionally, from what I have observed on www.nvest.me, Yahoo has been on the top of the trending topic for the past month and it is one of the most recommended stocks in that period. Recommendations on Yahoo are unanimous. Everybody (including Jim Cramer) on Nvest believe the IPO of Alibaba will lift the price higher.
As always, if you have any question or comment on the blog, you can message me at fred@nvest.me
Fred Zhou
Disclaimer: Always do your own research as these are recommendations and I make no guarantees. No one cares about your money more than you do!
Disclosure: I don’t have position in any of the stock I have mentioned above and I am no intention of taking position in the stock mentioned above in the next 5 days.
