Beware of the Fairytale Unicorn
July 14, 2017
Unicorns are mythical creatures that have piqued the interest of man for centuries. More recently, they have been affixed to private growth companies that reach $1 billion in valuation.
Many of these businesses have become household names, which tends to add to the notion of buying them when the equity becomes available to individual investors.
I’m the guy who is always talking about owning great American companies, but there is a caveat. You must stay away from companies that are overvalued, as too often the American public becomes some collective patsy for the elites of Silicon Valley and Wall Street.
There are some 200 unicorns out there right now and many are going public. My beef has and continues to be that all the value and growth opportunities are already sucked out of these IPOs. In the past, companies would go public a lot sooner, giving investors a chance to ride along toward market valuations and returns. Today, the public serves as the cashing out point.
I suspect the public is getting hip to all of this considering a couple of unicorns that have gone public recently have turned south since – Blue Apron (APRN) and Snap (SNAP) are now changing hands below their IPO prices. Keep in mind that a lot of small investors bought the stocks as soon as they began trading. Sure, they can come back – Facebook (FB) slumped beneath its IPO price for 14 months – but these companies aren’t Facebook.
More and more of these unicorns are busted public companies. So my warning is this: be careful of fairytale stocks – even those with good products – because for the most part, all the magic of investment returns might actually be gone.
How to Avoid Being Gorged
Coming into 2017, there was talk of approximately 20 so-called unicorns filing for initial public offerings before the end of the year. I’m not sure if that will happen, but I do expect more to debut against the backdrop of a broad market rally.
Here’s what you should avoid:
1. Silicon Valley and Wall Street Greed – Household names attract a lot of first-time investors who want a piece of the action – no matter the cost. For Facebook, this meant that the company was able to hike its IPO price from $28 to $38 and increase the number of shares issued. It squeezed every nickel of interest at the time and consequently when it opened, there were no fresh buyers. Twitter (TWTR) experienced something similar. It increased the price of its offering and while it was a winner for a while, it turned out that the company had leveraged public awareness to take advantage of individual investors.
2. Hype Versus Fundamentals – It’s becoming more common for investors to get an even shorter period of time to really look under the hood of the debuting company than what has already been a historically short timeframe. This is where you need to be careful. You want to make sure that the hot IPO is backed by a hot business. Two prime examples of this are King Digital Entertainment and Zynga (ZNGA), the parents of popular mobile apps Candy Crush and Farmville, respectively. There were clear sequential signs of slowing top-line growth when King Digital went public, which is why the stock landed with a thud. Similar misgivings were attributed to ZNGA, which tried to invent valuation metrics – a trend popular with Silicon Valley types – to justify the stock moving higher.
If a company admits its private valuation has gotten out of hand by going public with a lower valuation, then it’s not treating the general public like chumps. Square (SQ), which has become a hot stock and is considered a major takeover candidate, came public at a 25% discount to its private valuation.
It’s also important to consider letting the hype and early feeding frenzy fade before jumping in. I haven’t seen an IPO go on to be a long-term winner without initially dipping on early execution woes or massive insider lock-up expirations. (Company insiders and big stakeholders are restricted from selling their shares for a period of time after the public offering, and when that lock-up expires, a bunch of shares are often dumped in the market causing the price to dip.)
Of course, there are some exceptions to the rules. For example, if you’re willing to ride the waves, ask someone to hold your drink and chase names like Uber and Airbnb. But for the most part I’d recommend using this advice as a guide to how to make sure you’re not the chump holding the bag when the Silicon Valley billionaires fly off to their private islands.