When investing in IPOs, your time horizon should match your objective. Learn why momentum investing and long-term investing are two distinctly different animals.
Looking at growth opportunities in the market over the past year, particularly in companies that have recently gone public? Remember the words of Heraclitus:
“No man ever steps in the same river twice, for it’s not the same river and he’s not the same man.”
That’s a fancy, ancient Greek way of saying that change is constant. So if you’re one to follow the “hot money”, through initial public offerings (IPOs), direct public offerings (DPOs), or special-purpose acquisition companies (SPACs)—something most investors hadn’t heard of a year ago—just remember sometimes the “hot money” gets hotter, and sometimes it cools quickly.
If the COVID-19 pandemic has taught investors anything, it’s that Heraclitus was right, metaphorically: The ebb and flow of the market (“the river”) is a lot different than it was a year ago, and so is the investing public.
What might that mean for investors? To find potential high-growth market opportunities in IPO investments—the ones with staying power—you have to keep your eyes on the road ahead. But that road to IPO investments can be curvy, with limited visibility.
Getting a jump on emerging market trends means seeing and adapting to changes fast enough to avoid missing out but not hanging on too long if things change. And if you’re investing for the long term, make sure you’re following the long-term dynamics.
In other words, your time horizon should match your objective. Momentum investing and long-term investing are two distinctly different animals.
Remember that as you ponder these three investing lessons from 2020.
Many investors saw 2019 as “the year of the unicorn”—so-called disruptive companies carrying billion-dollar losses that were going public with valuations far exceeding their negative balance sheets.
The Ticker Tape published an article featuring three of these unicorns—two of them IPOs and one slated for public offering—that nearly promised to disrupt and redefine their respective industries: Uber (UBER), Lyft (LYFT), and WeWork. They were to usher in “the sharing economy,” where business became peer-to-peer rather than company-to-customer. It would be a social business revolution, just as companies like Facebook (FB), Snapchat (SNAP), and Twitter (TWTR) formed the social networking revolution.
But it wasn’t meant to be—not yet, anyway. UBER and LYFT got sideswiped viciously when COVID-19 crashed into the socially dependent sharing economy, replacing it with a socially distanced “stay-at-home” business environment. Although both ride-sharing companies are still in operation, a return to normal is unlikely in the foreseeable future, as travel demand is down and will probably stay that way awhile.
And then there’s WeWork. Well before coronavirus entered the vernacular, the rapidly expanding office-sharing network buckled under the weight of its own internal struggles (that happens sometimes) and had to put its IPO on ice. And even if it had gone public, the 2020 lockdown, quarantine, and general aversion to the office environment would surely have turned the WeWork business model upside down.
What did these three companies have in common in 2019? Despite their “disruptive” narratives, Uber, Lyft, and WeWork were still losing money. Before LYFT’s IPO, the company announced an annual loss of nearly $1 billion, but its IPO valuation was about $15 billion. UBER’s IPO pricing valued itself at $82.4 billion, yet it had lost $1.8 billion the year before its filing. And for the year prior to its failed IPO, WeWork reported a loss of $1.9 billion.
Lesson #1: A company can’t make it on narrative alone. Even if it’s not profitable in the short term, a company can survive for a while if there’s cash flow. But any disruption to that flow can quickly sour investors.
Alhough COVID-19 cooled the sharing economy and all things that center around in-person gathering, that heat was transferred elsewhere—to things that cater to the sheltered.
We still need to work, learn, socialize, and shop. In this new stay-at-home economy, there’s been a new set of darlings—Zoom (ZM) and Slack (WORK)—that play into the distributed workforce and schoolhouse.
Zooming to work and school (and happy hour). Before the pandemic made its impact—that is, when the S&P 500 made its highest high in mid-February—ZM, then a small video communications company and market newcomer, was already up 52.7% from the start of 2020. By October, its year-to-date performance jumped to a staggering 644%.
ZM does one thing and does it well: Its video conferencing platform can connect up to 100 people on the same screen (up to 1,000 if you purchase an add-on license). Some might call it a one-trick pony, but when the lockdown hit, this pony proved itself to be quite the workhorse.
Cutting companies a little Slack. Remember the olden days of team collaboration from different locales—managing group emails, accidentally including or omitting key people, and oh—that dreaded “Reply All” button? Slack (WORK) helped sweep away much of that awkwardness by providing a channel-based instant messaging platform. From online group meetings to screen-sharing online, Slack has become the go-to communications platform for businesses big and small.
But interestingly, after surging ahead in the early days of the pandemic, shares of WORK sagged after earnings fell short. As of Q3 2020, WORK has yet to turn in a profitable quarter. Meanwhile, ZM continued to surge. Although it has reported profits in every quarter since its 2019 IPO, and in 2020 ZM grew its customer base 458% year-over-year, the share price surge (see figure 1) has put its price-to-earnings (P/E) ratio around 700x as of October 2020.
The dynamics of the stay-at-home economy are still unfolding, so it’s hard to write the conclusion here. The key, however, will be determining whether these firms have staying power once the economy returns to some semblance of normal. Will ZM and WORK have a place, or will they succumb to competition from an ever-crowding field that includes Microsoft (MSFT) Teams, Google Meet, and other communication portals? More importantly, will ZM and WORK become profitable?
Lesson #2: It’s all about adaptability. A company’s staying power depends on how well it can adapt its business model to current and future business environments.
Why is it that some companies can withstand early storms on their way to profitability? For example, three FAANGs—Amazon (AMZN), Alphabet (GOOGL), and Netflix (NFLX)—have seen investors who were willing to forgo short-term profits on the way to long term. These and other big tech firms went public at relatively early stages of company life and (eventually) succeeded spectacularly.
It’s about the long game. Hockey great Wayne Gretzky talked about skating not to where the puck is, but where it’s going to be. Remember when AMZN was just an upstart online bookseller that lost 10 cents per book sold? At that time GOOGL was a search engine that gave away its core product for free, and NFLX distributed DVDs to subscribers by mail. But early investors in these firms looked beyond the present day to the future—the “Amazonification” of industry after industry: Amazon Web Services, Google’s AdWords and integrated platforms and services, and NFLX’s move into streaming content, which finally demonstrated why it had “net” in its name.
None of these things happened overnight, of course. Each new initiative took time to come to profitable fruition. Not coincidentally, AMZN, GOOGL, and NFLX were all in a position to benefit when the lockdown hit.
Lesson #3: Patience is a virtue. Like a freshly planted tree, new ideas and industries can take many years to bear fruit. IPO investing isn’t necessarily about riding short-term momentum, but rather playing the long game.
Reality has a way of disrupting even the most robust of plans. Last year’s “sharing economy” and this year’s “stay-at-home” shift are testaments to the disruptive dice that the world can sometimes throw. Although the market can change on a dime, it shouldn’t rock your long-term investment goals with the same speed and volatility.
One key consideration is looking past what was and what is to what could be. That means doing your homework—looking at trends, opportunities, and threats, listening to corporate earnings calls to see how companies are positioning themselves for the long term, and ultimately diversifying your holdings when investing in emerging companies (especially highly speculative IPOs in emerging industries). That can go a long way toward separating the “flash-in-the-pan” from the long-term disruptor.
Before investing in an Initial Public Offering, be sure that you are fully aware of the risks involved with this type of investing. There are a variety of risk factors typically associated with investing in new issue securities, any one of which may have a material and adverse effect on the price of the issuer’s common stock. For a review of some of the more significant factors and special risks related to IPOs, we urge you to read our Risk Disclosure Statement.
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