I purchased a stock when it went public last year. A major brokerage house was the underwriter and had a price target of $30 on the stock. I thought it was a good idea to purchase the stock at $18 as I thought it would go to $30. The stock, as of yesterday, was trading below $1. How could the brokerage get it so wrong?
Didn’t the analyst, a professional, do due diligence before releasing such a high price target to the public? It seems they put a high price target to generate interest in the IPO. Is this ethical? Granted, other firms cut their price targets on the stock a lot also, but the underwriter had the highest target. I feel like a “sucker” purchasing it so high.
Feeling Like A Fool
The underwriter wants to make money. The management wants to make money. Brokers want to make money. And the investors want to make money. Everybody’s got their name in the hat for the same reason. Not everyone wins. And, sometimes, everyone loses. (I removed the name of the brokerage house and company from your letter, and read the company’s own description of its services, and I still have no clue about what it does. I trust you have/had a better idea.)
It’s a game of a chance, and no one, as any IPO prospectus will inform you, can predict the future. That’s why before going public, companies warn investors that the stock can go down as well as up, the company might go out of business, and myriad other possible disasters. You buy at your own risk, and major brokerage houses — even those that were underwriters for the IPO — often cut their own price targets for the stock, as happened in this case.
The analysts who underwrote the IPO, and wrote the initial investor report before the IPO work on the “buy” side of the brokerage. The analysts who evaluate a company’s financial results, competitors, management skills and other corporate plans after the IPO are on the “sell” side. This is the brokerage side of an investment bank, and these analysts are supposed to arrive at their own objective opinions, irrespective of an investment bank’s role as the underwriter.
Every investor wants to get in on the ground floor of the next Tesla
In his book, “The Wall Street Waltz,” wealth manager Ken Fisher has a pretty straightforward, if refreshingly blunt, explanation for your dilemma. “IPO stocks often rise immediately, because the brokers selling them are getting sales commissions of several percent for their hype, so they create lots of mindless momentum around these issues,” he writes.
“‘Looking at an investor who made a fortune on an individual stock is like listening to that person who wins an Oscar, and says you can manifest your destiny and don’t give up on your dreams.’”
“Investors get suckered in by the excitement and by dreams of a big hit,” Fisher added. “And they usually get hit, because companies raise money through stock offerings only when the price is great for them — which is too high on average to be a good deal for buyers. Soon the hype wears off and the stocks get clobbered.” The era of the metaverse and social media has not changed that. How do I know? Fisher wrote those cautionary words a year before the 2008 financial crash.
Investors, however, often complain about the opposite problem: IPOs are frequently underpriced and this issue is among the most widely studied anomalies in equity markets. This recent review looked at a large body of research on the subject, and concluded that firms want to raise their profile as well as raise money, and concluded that underpricing is largely due to “information asymmetry.” In plain English, that refers to one or more parties having more information than others.
“Some investors are more informed than others. In other words, they have better knowledge of the quality of firms, which firms are underpriced or overpriced,” the author Kelai Wang wrote. His other conclusions may apply to your case of an overpriced IPO too: “Due to capital constraints, it is assumed that the stock market is not filled entirely by informed investors. IPOs must be set underpriced to keep the less informed investors within the market.”
Investing in individual stocks is a fool’s game, unless you bought Apple 40 years ago at $22 a share. But even those who did that and tell you that success can be reaped from buying an individual stock (a) likely bought the stock a long time ago, (b) held onto it for a long time and (c) got lucky. Looking at an investor who made a fortune on an individual stock is like listening to that person who wins an Oscar, and says you can manifest your destiny and don’t give up on your dreams.
They believe it because they did it, and they want you to believe you can do it too. Of course, some find a lucrative side hustle promoting their theory of how to become rich and famous by reverse engineering their own good fortune, and selling it to the masses. They write books about how to get rich (quick), give TED talks about how to get rich (quick), and appear on their own television shows about how to get rich (quick). But remember: even Warren Buffett makes mistakes.
It’s easier to get rich slowly through real estate, compound interest and saving for retirement. If you decide to hold onto this stock, get back to me in 40 years.
You can email The Moneyist with any financial and ethical questions at [email protected], and follow Quentin Fottrell on Twitter.
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