LinkedIn IPO

[Repost from my contribution to Morningstar Advisor] LinkedIn LNKD rallied more than 100% in its first day of trading. The market is buzzing about its spectacular performance. Even I, a known advocate of passive investment among my friends and clients, got calls asking if it’s a good time to invest in this stock. It’s not, emphatically. Here are three reasons:

Insider Advantage
LinkedIn has been in business since 2003. Who decided that it should go public now, as opposed to March 2009? Surprise! It’s the management of the company, acting in the interest of its shareholders. In LinkedIn’s case, it’s Reid Hoffman, who is both CEO and a major shareholder. Did Reid do that so that you could buy his shares at an undervalued price? I bet not. And for that matter, he was willing to sell shares at a pricing range of $32 to $35. The pricing range was only raised to $42 to $45 after popular demand from investment bankers.

Winner’s Curse
Winner’s curse describes what often occurs in a common value auction with incomplete information. Different people have different valuations of the object in auction; the person who wins the auction is the one who values it the highest. Unless other auction participants are brain dead, the person who values the object the highest almost surely overvalues it. Winner’s curse is an apt description of what’s occurring in the IPO market. What else can explain why LinkedIn shares are trading at over $90, almost three times what its CEO thought was a good price?

Historical Evidence
In 1995, two professors, Loughran and Ritters, did a study of IPO stock performance between 1970 to 1990. Their result was published in the Journal of Finance. They found IPO stocks underperformed significantly during the first five years after issue. Specifically, IPO stocks underperformed similar-sized seasoned stocks by 44%!

In the more recent decade, the majority of red hot dot-com IPO stocks disappeared within five years. Anybody remember Pets.com? Investors, as human as they are, quickly forget the 97% of dot-com stocks that failed but hold on to the fairy tales of the 3% that succeeded.

In conclusion, I have nothing against LinkedIn. In fact, I love its service, but good service does not equate to good investment. As a general principle of prudent investing, I recommend avoiding IPO stocks, whether it’s LinkedIn or any other “hot” IPO du jour.

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