Is the IPO market too hot?

The market operates in cycles. Things heat up; things cool off.

When people tell you to “look through the cycle,” they are referring to the need to ignore the short-term fluctuations and invest in high-quality companies that will do well over an extended period.

I often reference Microsoft as a powerful example of this. It is the only company that was among the ten most valuable companies in the world in 2008 (the end of the 2000s bull market for banking and “real assets”) and still holds that status today (after a bull market for tech stocks).

A bull market is a period of stocks going up in value, while a bear market indicates a period of stocks either going sideways or decreasing in value. The typical Wall Street portrayal of the bull against the bear is founded in this terminology.

The biggest question is whether the bull market for these tech stocks is coming to an end or not.

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The IPO market is piping hot

The Initial Public Offering (IPO) market is a reasonable barometer for potential trouble in the market. There’s nothing more exciting than a company coming to market for the first time and raising money, but the level of exuberance is sometimes simply over the top.

Three of the ten biggest U.S. IPOs of all-time happened this year, although the latest IPOs only occupy mid-level positions in that list.

Facebook still tops the table (raised $16bn in May 2012) and Uber is in second place ($8.1bn in May 2019). We need to go all the way back to the days of the Dot Com Bubble to find Agere Systems (which was an integrated circuit components company) in third place, having raised $4.1bn in 2001.

After Snap ($3.9bn in March 2017), we finally arrive at the 2020 newbies in positions five to seven respectively: Snowflake, Airbnb and DoorDash.

For me, Snowflake (a data cloud business that went public in September) is notable for Warren Buffett having participated in the IPO. Sure, he got pre-listing stock at a great price through Berkshire Hathaway (his world-famous investment company), but it was quite something to see his group participate in a tech IPO.

It shows how even a traditional value investor like Buffett has amended his approach in the past few years to take cognisance of the tech opportunity.

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The profits don’t matter, right?

DoorDash and Airbnb both went public in the past week or so. DoorDash is a food delivery business (like Uber Eats) and Airbnb is the ingenious platform that provides accommodation across the world without owning a single hotel.

Our contributor The Creative Accountant wrote a detailed piece on Airbnb a few weeks ago.

Both these companies were funded for years by venture capital and private equity houses, taking them into double-digit billions territory. Both companies are loss-making and raised $3 billion as part of the listing.

DoorDash jumped 85% on the first day of trading and Airbnb did even better, up over 110% on its first day. The mad rush for stock in these companies has even left company executives flabbergasted, with Airbnb co-founder and CEO Brian Chesky visibly shocked by the share price performance.

How hot is too hot?

I’ve invested in several tech companies in 2020 and I’ve specifically focused on businesses that have a proven ability to generate substantial free cash flows. For example, I invested in Apple and Microsoft, but I avoided Netflix, Tesla and Zoom.

Sure, I missed out on some mega returns this year (although I did well overall), but chasing every bubble isn’t an investment strategy. I’m a long-term investor, so I can’t buy into companies that I believe will have a disappointing 2021 (and beyond). In the cases of Netflix and Tesla, I’ve shared my concerns several times before on The Finance Ghost.

The valuations we are seeing in the latest IPOs are truly staggering. I don’t believe we are in Dot Com Bubble territory as a whole, but I’m not rushing to put more money into my favourite tech stocks and I’m especially not investing in these fringe players at heavily inflated valuations.

A number of respected market commentators have expressed concern at the frothy IPO market, often an indicator that we may have reached a short-term peak. I agree with that view.

Stocks don’t always go up, a lesson that I suspect many will learn in 2021. Stick to your strategy, make sensible decisions and avoid getting caught up in the hype.

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