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Will Investors Ever Learn to Avoid Money-Losing Companies?

October 18, 2013
URL: http://www.entrepreneur.com/article/229501

If you are an investor, you can be comfortable avoiding the 2013 crop of initial public stock offerings. After all, according to Jay Ritter, a professor at the University of Florida, Twitter, which lost $79 million in 2012 and is poised for a bigger 2013 loss, is hardly alone in losing money as it prepares to go public. Ritter’s statistics say that 68 percent of this year’s IPOs were also losing money.

Why are investors bidding on the shares? It certainly is not because the price of their stock is less than the current value of their future cash flows. After all, based on their history, there is no basis for concluding that these unprofitable companies will ever make money.

But that’s the beauty of the stock story for a money-losing company. If it were making a profit before its IPO, it would be harder to make outrageous forecasts about how much more money the company will make in the future.

But when a company is losing money, the sky’s the limit when it comes to predicting how bright its future will be.

Along with that ability to forecast a spectacularly profitable future is the fine functioning of one of finance’s most basic laws: momentum. That is -- a stock that is going up will rise more just because it is going up.

More specifically, when there is no real positive cash flows on which to value a stock, its price will rise because investors who do not own the shares will be afraid they are missing the party. So they decide to buy the shares. And if they are lucky, their buying will drive up the shares further, which will attract a new crop of fools -- I mean, investors.

28 tech companies have gone public so far in 2013, but this year’s post-IPO performance has been the best since the peak of the dot-com bubble of the 1990s. On average, those 28 stocks have gone up 39 percent in the first month after they went public.

Although this year’s crop has been largely made up of money losers, Ritter argues that over a longer period of time, the companies that go public with a profit do better in the stock market. His analysis of profitable tech companies that went public between 1990 and 2011 found that their stock prices rose 55 percent in the first three years of trading, while their money-losing brethren enjoyed only a 22 percent rise during those three years.

Is there another bubble brewing? Maybe -- but we are nowhere near the point of explosion. We will know we are there when we get into a taxi and the driver is giving us hot tips on the latest IPO that he heard from the hedge fund honcho he just dropped off on Wall Street.

In the meantime, Ritter’s statistics suggest that you would be better off avoiding the money-losing IPOs and stick to companies that take the trouble to make a profit before they try to sell you their shares for the first time.

Unfortunately, the hapless investor is left with a very fundamental problem. There is no reliable basis on which to explain why stocks go up and down. You're probably better off just investing in a stock index fund with low expenses than gambling on an individual stock.

That said, if you’re running a startup that has at least $100 million in revenues and is growing over 30 percent a year, odds are good that you can hire several investment banks and they will be happy to take your company public -- whether it makes a profit or not.