Why You Should Not Judge an IPO at Face Value

GoDaddy, Inc. (GDDY), the company best known for its commercials featuring race car driver Danica Patrick, dominated headlines yesterday as investors flocked to buy shares during the Web hosting site’s stock market debut. GDDY shares rose nearly 34% and the company’s value was up to $5.48 billion, including debt. However, while many in Wall Street raced to buy GDDY, they might’ve hit the gas too soon.

While IPOs are a good thing for the market, they’re not always a good thing for investors. Often these offerings are met with insider selling that makes owning the stock dangerous for individual investors. So generally, I recommend staying on the sidelines when an initial offering rolls into town, no matter how hot the stock is.

Far too often, these deals are structured so that insiders and backers get the best price, and then they tend to dump shares on the market after the “lock-up” period expires. That’s why you tend to see share prices fall off a cliff a few months after the IPO.

The truth of the matter is that the stock investors like inflation; they do not like deflation. Every time the dollar rallies, it creates deflation; so that’s why we’re seeing the market pull back. And as we saw on Monday, it doesn’t take long for investors to realize the benefits of deflation, and the market rights itself.

That’s exactly what we’ve seen with GoPro, Inc. (GPRO), which had its IPO last summer. After surging during the first few months, GPRO has fallen hard. The stock is down over 30% year-to-date, and it’s still trading at over 25 times forecasted earnings. Another red flag is that this year, GoPro is expected to post just 4.5% earnings growth.

And more recently Shake Shack, Inc. (SHAK) had its IPO in late January, and the stock has had some pretty wild swings since then. Due to the hype surrounding the burger joint, SHAK tends to sustain steeper drops on down days for the market. For instance, yesterday SHAK was down near 4%, when the market had pulled back about 0.5%.

It’s important to keep stories like this in mind for future IPOs. Online marketplace Etsy also recently announced its plan to go public next month. The company announced on Tuesday that it plans to raise as much as $266.7 million for its IPO and expects to sell at $14 to $16 per share. Already there’s plenty of buzz surrounding Etsy, with estimates that its market value could hit $1.2 billion, 52 times its adjusted earnings before EBITDA for the previous year.

Now, if that sounds too good to be true, it probably is. Many are failing to highlight the fact that while Etsy’s sales jumped $56% last year to $195.6 million, the company also lost $15 million. Also, of the 16.7 million shares that are set to be sold for the IPO, only 13.3 million come from Etsy, the rest will come from existing investors.

The list goes on and on, and this is why I don’t recommend buying IPOs. There’s too much volatility early on, and unless you can get a sweet deal on these offerings, you’re probably going to get hosed.

If you want to get into these companies, I recommend that you come back in a year or two and then consider adding these companies. And I say that for one specific reason–earnings results.

A company needs at least four quarters’ worth of data before you can really assess if it has the growth needed to be a successful investment. And that’s what’s really hot right now–especially given that earnings season is right around the corner.

After any major market rally like what we saw at the end of last year, investors take profits off the table and move them into the fundamentally strong companies they see as the next winners. This is called a “flight to quality.” Investors want to go with established companies with solid fundamentals that they can trust.

This is why now is such a compelling time to be a growth investor who focuses on fundamentals.

If you’ve followed me for any length of time, you know that I follow eight key metrics that have been proven to determine the financial health of a company. I watch sales growth, operating margin growth, earnings growth, earnings momentum, earnings surprises, analyst earnings revisions, cash flow and return on equity. If your investments get passing grades in these eight areas, you can sleep easy.

I urge you to run all of your stocks through my ratings tool to see how they stack up. And you can do it for free at PortfolioGrader.com.

Sincerely,

Louis Navellier

Louis Navellier

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